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Islamic Capital Markets in Asia, Emerging Challenges and New Entrants

by Edmond Lau, Executive Director (Monetary Management), Hong Kong Monetary Authority

(Keynote Address at the 2008 London Sukuk Summit)

25 June 2008

Good morning ladies and gentlemen.

  1. It was a great pleasure for me to be invited to speak at the 2008 London Sukuk Summit. Hong Kong is among the newest members of a growing group of financial centres seeking to introduce Islamic finance into their mainstream financial systems. I was particularly happy for this opportunity to share our thoughts on positioning Hong Kong for the emerging opportunities of Islamic finance and the challenges in developing this new business from the Asian perspective.
  2. The remarkable growth prospects of Islamic finance in global financial systems have been extensively discussed in the past decade and are now recoginsed globally. This new wave of capital flows began with the oil-rich nations in the Middle East seeking financial products elsewhere in the world that comply with the tenets of Islam. In recent years, such flows have become increasingly associated with Asia.
  3. The total capital flow into Asia may not be easy to quantify, but it is obviously reflected in the growing trade relations between the Middle East and Asia. According to the IMF, two-way trade flows between the Gulf Cooperation Council nations of Saudi Arabia, Bahrain, Kuwait, Oman, Qatar, and the UAE, and Asia excluding Japan, have expanded four times in the past decade to US$22 billion in 2006. That represents an equivalent of 15% compounded annual growth, a reflection of the close economic connection between the GCC and Asian economies.
  4. Providing a strong impetus to the growing interaction between the Middle East and Asia is the rising price of oil and the resulting accumulation of wealth in the Islamic world. The growing desire for portfolio diversification away from traditional asset-management centres has also fuelled the search for local and regional investment opportunities. The sustained high growth in Asia, underpinned by China's emergence as one of the world's major economic powerhouses, has obvious attractions for Middle Eastern liquidity seeking investment opportunities.
  5. And it appears that what we are seeing now is just the beginning. According to a survey conducted by the Economist Intelligence Unit on behalf of the Qatar Financial Centre, 59% of Middle East financial-service professionals said that they expected a significant rise in Islamic finance products in the next three years. Over 20% of the correspondents also indicated that they expected the Asia Pacific region to attract the largest portion of equity investment among their Middle East clients. These figures clearly reflect the growing interest of Middle Eastern investors in the Asian financial economy. The survey also suggests that diversification has become a real issue.
  6. Market potential aside, considering how far these demands have been met by our financial markets so far, it is astonishing that the global Islamic finance industry, which is estimated to be worth US$1 trillion, is dwarfed several times over by the potential new demand generated every year. Standard & Poor's estimates that the current size of global Shariah-compliant assets to be worth US$400 billion, which is equivalent to roughly 10% of the GDP of the nations in the Organisation of The Islamic Conference or OIC. It also estimates that the potential market for Islamic financial services is close to US$4 trillion. The Islamic finance industry, however substantial it already is, has not been accelerating fast enough to match the growth in Islamic wealth. The development of Islamic finance therefore calls for new entrants into this market and needs to take on a new dimension of promoting greater financial intermediation across jurisdictions in different regions.
  7. This is why Hong Kong is seeking to become an important player in the booming Islamic finance arena by providing a platform for Middle East investors to access investment opportunities in the Asia Pacific region. In the opposite direction, Hong Kong can also leverage on its experience, innovation and market diversification to serve as a capital-raising centre for Middle Eastern issuers to tap the funds made available by the high savings rate in the region, in particular China. As a frontrunner in international finance, which possesses key strengths in financial intermediation on an international scale to bring together investors and fund raisers from different parts of the world, Hong Kong can, and should, likewise take on the intermediary role for Islamic financial products, just as it currently does for conventional products with a high degree of sophistication across all asset classes.
  8. With only a small Muslim population, some people have questioned how Hong Kong could play a role in these segments of the market. But market players in Hong Kong have answered this scepticism by quickly introducing our first Shariah-compliant product. In late 2007, shortly after the Chief Executive of the HKSAR unveiled the government's policy of developing Islamic finance in his 2007 Policy Address, we witnessed the first Islamic fund introduced by a local bank in Hong Kong. The fund tracks the performance of the Dow Jones Islamic Market China/Hong Kong Titans Index. In May this year, a new Dow Jones Islamic Market Index was launched to track China-related equities listed in the Hong Kong stock exchange, further enriching the Islamic index infrastructure in Hong Kong. These initiatives clearly demonstrate the dynamism of Hong Kong's financial systems in responding to an emerging market opportunity.
  9. As mentioned earlier, it is a fact that Hong Kong's Islamic community is not big, but we are confident that the development of Shariah-compliant financial markets can take off even in environments in which the domestic Islamic community is relatively small, simply because investors nowadays are looking beyond domestic boundaries and traditional finances as financial activities gravitate towards the Middle East and China. Indeed Hong Kong's relatively small population does not seem to undermine in any way our performance in the conventional financial and capital markets. Therefore we are not positioning ourselves as a market that can match the supply and demand of Islamic products from a domestic angle. Our objective is to make Hong Kong a platform for the wholesale Islamic financial activities.
  10. What makes Hong Kong a natural destination for Islamic funds is our deep and highly liquid capital markets. Almost all of the most actively traded financial instruments are available for exchange in Hong Kong, and this gives Islamic investors a much wider choice of where to place their funds.
  11. More importantly, when it comes to investing in China, Hong Kong is the obvious choice. Hong Kong has the largest and deepest Chinese equity and debt markets outside Mainland China. We are the first and remain the only major international financial centre that has banking business and financial products related to the renminbi. The development of a local renminbi bond market which started in the middle of last year has firmly positioned Hong Kong as a proving ground for China's continuing financial market liberalisation.
  12. International investors can readily gain exposures to different sectors of China through the Hong Kong platform. For example, investors wanting to access China's property market can make use of the Real Estate Investment Trusts listed in Hong Kong with underlying exposures to properties in Mainland China. There has also been encouraging innovation in combining sukuk with China equity exposures. The successful launch earlier this year by a Malaysian issuer of an exchangeable sukuk linked to the underlying shares of a Mainland China company listed on the Hong Kong stock exchange is a case in point. The exchangeable sukuk attracted a high subscription from Middle Eastern investors and reaffirmed the keen demand for investment opportunities with China growth prospects through the Hong Kong platform.
  13. As I mentioned earlier, the Islamic financial sector has huge headroom for growth and needs new entrants. In Asia, there is no shortage of financial centres wanting to get into this market. There are some financial centres which have already gained a head start and there are some others which are fast catching up. We believe this is not a zero-sum game as we can all grow together with an ever larger Islamic financial market and benefit from the greater efficiency, diversity and stability of a deeper capital market. Hong Kong is therefore committed to working in close collaboration with other markets in Asia to establish a deep and integrated Islamic capital market in Asia. Admittedly this is no easy task as we have not yet been able to do this for the conventional capital market.
  14. Financial integration in Asia, as compared to international financial integration generally, is probably less developed. Financial integration refers to the mobilisation and channelling of savings into investments across jurisdictions rather than just domestically. Asian economies have probably lent more individually to, for example, the United States, than they have collectively to other Asian economies. Yet, more than half of the total trade in Asia is intra-regional, reflecting that Asia is becoming increasingly economically inter-dependent. Relatively speaking, our financial relationship is underdeveloped compared with our economic and, in particular, trade relationship.
  15. Given the current state of financial integration in Asia, the development of Islamic capital markets involving cross-border movement of funds is challenging as it has to address many of the existing impediments to greater financial integration in the region. But Islamic financial intermediation could provide a strong catalyst for change and growth in the Asian capital markets, many of which are now awakening to the potential for Islamic finance to leapfrog developments in capital markets. So there are both challenges and opportunities in this process.
  16. In the next few minutes, I'm going to analyse some of the key elements that are needed to strengthen financial intermediation and developing Islamic capital markets in Asia.
  17. The first is the establishment of links between jurisdictions across the whole spectrum of financial infrastructure - the trading, payment, clearing and settlement and custodian systems for money, debt and other financial instruments, since these provide the basic infrastructure for the movement of savings between jurisdictions and make cross-border transactions more efficient. Just like conventional instruments, Islamic capital markets will benefit from an efficient and effective network that reduces or removes uncertainties and risks in clearing and settling financial transactions. The availability of a coherent and effective financial infrastructure network is also conducive to market development.
  18. A valid example of such linkage co-operation is the settlement link between Hong Kong and Malaysia enabling instantaneous transfer of US dollar-ringgit foreign exchange transactions and US dollar-denominated securities lodged with the central bank of Malaysia. The payment-versus-payment (PvP) and delivery-versus-payment (DvP) links established between Hong Kong and Malaysia have helped strengthen integration of our financial markets. Imagine if a US dollar-denominated sukuk is to be launched in Malaysia, targeting investors in Asia and Mainland China who have a certain portion of their wealth managed in Hong Kong. By striking the deal and initiating settlement locally, we can have funds transferred electronically to the issuer in Malaysia and securities credited to the investors in Hong Kong in synchronised manner using the DvP mode. This sort of transfer can take place locally with a high degree of certainty (in terms of finality of settlement) and efficiency during Asian business hours.
  19. The second element relates to the relaxation of non-supervisory restrictions, where they exist, on access by foreign financial intermediaries to the domestic markets. We are beginning to see some efforts made by jurisdictions in this region, such as the mutual recognition agreement between the Malaysia Securities Commission and Dubai Financial Services Authority (DFSA) for the cross-border marketing and distribution of Islamic funds between the two countries. Hong Kong has already established a framework of co-operation with the Dubai International Financial Centre (DIFC) Authority to look at market facilitation measures including possibilities of removing non-supervisory restrictions on Islamic capital instruments.
  20. The third element concerns the harmonisation of standards in the financial system. Islamic finance has given new meaning to harmonisation and standardisation. Not only is there a need for market harmonisation of standards on a practical and operational perspective with regards, for instance, to product structures and legal contracts, but also another layer of harmonisation attributable to the regulation and supervision of Islamic finance products. Regulatory harmonisation is an imminent issue for new entrants such as Hong Kong in shaping the architecture for Islamic finance, particularly in relation to the establishment of a taxation framework to provide a level playing field for Islamic financial transactions. As there is not yet convergence of a global standard on Shariah compliance, different countries seem to have adopted different approaches in defining the standards for Shariah-compliant products in determining, for example, the granting of tax neutrality treatment. In Singapore, the relevant regulations require the endorsement of the relevant financial product by a Shariah board or committee of the issuer or arranger. In Malaysia, the authorities have even set up a national Shariah Advisory Council for approving all Shariah instruments, thereby harmonising the standards at least within the country. In the UK, the law describes the salient features of different types of Islamic financing arrangements without a specific reference to Shariah or any religious label for the purpose of granting tax exemption. The onus seems to rest on the issuer or arranger to satisfy himself that the requirements of the law can be met without the need for an approval mechanism. The policy choice of each jurisdiction is determined having regard to its own circumstances and there is no hard and fast rule in determining an optimal solution. Hong Kong is reviewing its tax law with a view to providing tax neutrality to Islamic financial transactions and will take into account the experience of other financial centres in this regard.
  21. The forth element concerns the strengthening of regional co-operation. Whether on a bilateral basis or in the context of a multilateral initiative, strengthening dialogue and stepping up regional co-operation can expose regulators to developments elsewhere in the region and create an environment conducive to a higher degree of regulatory harmonisation. There is also scope for further development to increase the diversity of financial intermediation channels in individual jurisdictions in the region and for sharing experience in development efforts. This explains why Hong Kong has committed itself strongly to the efforts made by international organisations like the Islamic Financial Services Board (IFSB). The Hong Kong Monetary Authority has become an associate member of the Board which enables us to take part in international dialogue and make reference to prudential standards and guiding principles established by the Board for the Islamic financial industry.
  22. The fifth element is the need for greater capital mobility in general. It is hard to advocate lifting all restrictions on cross-border investment as this would depend on the ability of the financial systems in individual jurisdictions to cope with the ensuing risks. However, it is apparent that greater capital mobility is the necessary condition for financial integration across jurisdictions. The relaxation of controls on cross-border transactions can drive more efficient allocation of resources. It is also a mark of financial openness crucial to the attraction of global players in entering into Islamic finance businesses in local markets in Asia. Ultimately this should be conducive to the development of a larger capital market with greater breadth and depth.
  23. Last but not least, the sixth element is the need to nurture a larger pool of talent with expertise in Islamic finance. Significant strides have been made over the past few years in Islamic finance, but the talent pool is too small to meet global needs. As a new entrant, Hong Kong has to leverage on the expertise of the major international banks in other parts of the group in structuring Shariah compliant financial products. But in future, we will have to deepen the market knowledge within Hong Kong about Islamic finance products. In this regard, the local industry bodies such as the accounting association and treasury market association can play a significant role by providing a forum for open and useful discussion and the sharing of experience by experts in this field, thereby enhancing the knowledge of all market players.
  24. This morning, I have briefly described how a new entrant like Hong Kong could contribute to the development of Islamic finance and outlined a few macro issues that the Islamic capital markets in Asia are currently facing, with the objective of drawing greater attention and efforts to addressing those issues. For the purpose of promoting the stability, integrity, diversity and efficiency of financial intermediation across jurisdictions in Asia, it is crucial that Asian markets work more closely together to seize the opportunities brought by Islamic finance. As a result, Asia will be in a better position to benefit from a higher retention of savings in our own region. The greater stability and efficiency in capital flows in the region will also enhance diversification and integrity of financial markets in Asia.
  25. Thank you very much.
Last revision date: 1 August 2011
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