February 15, 2016
In this issue…
- Islamic asset management set to grow in Turkey and could help attract responsible investment
- Qatar’s Islamic bank profits depend on health of real estate and consumer financing
The week’s lead market story was the pricing in of challenges facing European banks as a result of negative interest rate policy reducing their ability to make enough money to retain investors (what the FT Alphaville blog calls the ‘death of banking’). This will affect Islamic banking particularly in the GCC as European banks are forced to reconsider whether to remain in non-core markets just as they did in 2008/09 and 2011/12. Each time, it has opened market potential for regional Islamic banks and this time should be no different despite the challenges caused by low oil prices.
Although details are sparce, the launch of a new Islamic asset management company by Kuveyt Turk, the Turkish affiliate of Kuwait Finance House, may contribute to the development of Islamic fund management in Turkey and could contribute to financial market development in Turkey and mobilize savings. If successful in attracting investment assets from abroad, it would also contribute to lowering Turkey’s current account deficit.
The growth in asset management offerings from banks is not just a story in Turkey—a survey conducted for the Finance Forward Islamic Finance Outlook Report 2016 found that almost a majority (46%) of banks said that asset management would be one of the top three sources of revenue growth. Turkey’s equity market is relatively underdeveloped relative to the size of its economy (it is a member and was the most recent host for the G-20 meetings as the world’s 17th largest economy). At just 27.5% of GDP, the total market capitalization is far below comparable emerging markets.
The small equity market is also notable give the very successful private pensions reform, expanded in 2013 to include government matching contributions and tax incentives, that has led to a rapid growth of private pensions. These that now cover close to 6 million people and have assets of €12.2 billion ($13.7 billion). However, these private pension assets are not contributing much to developing the domestic equity market; only 12.5% are invested in equities.
The private pensions were developed to help raise Turkey’s domestic savings rate which is low compared to other emerging markets at just 15.8% of GDP in 2014 according to the World Bank. Other large emerging markets have higher savings rates like Brazil (17.3%) and South Africa (18.5%). Even these are below higher income Malaysia which has a domestic savings rate of 34.3% and China, where limited alternative avenues for savings exist, has led the savings rate to be 49.9%.
A growing part of the private pensions market is now done through an Islamic pension insurer owned jointly by Kuveyt Turk and Albaraka Turk (Katılım Emeklilik). Adding an Islamic asset management company alongside it could help expand the meagre share of Islamic fund assets which today only amount to $13 million across 5 funds according to data from Thomson Reuters as of the end of January 2016.
Another angle to appeal to the Islamic market and other investors, particularly those from Europe, is to expand the use of responsible investment that integrates environmental, social and governance (ESG) factors. This is not just something which can be done to attract European investors but can more fully align with Islamic principles and deliver a socially impactful product to appeal to the Millennials who see Shariah compliance as just a minimum starting point for implementing the Islamic ethical approach.
The growth potential is significant, for both Turkish investors and foreign investors. GCC investors can find in Turkey a large regional economy that is not correlated with their home markets because of a more diverse (and not oil dependent) economy. Responsible investors from beyond the MENA region are recognizing the long-term opportunity in emerging markets due to the longer-term growth potential and will have to increase their emerging markets allocation in the future.
The International Finance Corporation (IFC) estimated that as of the end of 2014, responsible investment by foreign investors in Turkey amounted to just $3 billion, and less than $1 billion was from signatories to the Principles for Responsible Investment who, in total, managed $45 trillion as of 2014 and $59 trillion as of 2015. This leaves a sizeable gap between the current size of the responsible finance assets in Turkey and the proportion that would be expected if the asset were split globally on the relative economic size. Turkey’s economy, the world’s 17th largest, represents just over 1% of the global economy.
Qatar’s banking system is one of the more insulated among the GCC due to its small population (meaning a lower public sector wage bill) and ongoing investment in other sectors in preparation for the 2022 World Cup which, combined with the lower oil receipts, has dropped oil’s share of GDP to under 40% during the first half of 2015 compared to nearly 60% in 2012.
The reduction in government revenue is likely to have the most dramatic effect on private sector financing and Islamic banks have relatively more exposure particularly in the real estate and consumer financing sectors making performance in these areas a bellwether for Islamic bank performance relative to conventional banks.
Another area to watch the effect of lower liquidity is through the effects of a sharp rise in the loan-to-deposit ratio which rose by 14 percentage points over a 12 month period from November 2014 to November 2015, reaching 117%. This increase in the loan-to-deposit ratio is significant for a banking system with over QR 1.1 trillion ($304 billion) in total assets and occurred due to year-on-year growth in assets of 19% compared to 5% growth in deposits.
The rise was even more dramatic for Islamic banks where the financing-to-deposit ratio is 121%. Such a high ratio does not indicate an immediate risk because Qatar’s banks (and its Islamic banks in particular) are extremely well capitalized. They are have significantly less reliance on financing from foreign banks which is important for their stability if European banks started pulling away from markets like Qatar.
The risk remains, however, because Qatar’s Islamic banks have largely replaced the exposure to foreign banks with funding from banks in Qatar. If these banks are affected by a withdrawal of liquidity from the region, it would have a spillover effect on Islamic banks by amplifying the cost of interbank liquidity within Qatar (which is already expected to occur on the basis of the rise in the loan-to-deposit ratio across the banking sector).
By driving the cost of interbank funding across the board, it would have the effect of narrowing the margins and squeezing profits at a time when rising non-performing loans are also weighing on banks in Qatar. The reserves built up from years of higher oil & gas prices gives Qatar a bigger buffer than other countries in the region to maintain not just the regular government expenditure but also the infrastructure spending for World Cup 2022.
However, it is not entirely clear that Islamic banks will get as much support from this channel as conventional banks. Islamic banks, which account for 29% of the banking assets in Qatar, have 20% exposure in their financing to the public sector compared with 37% for conventional banks. They make up for the bulk of this exposure with higher exposure to real estate and consumer financing where they have 20% and 21%, respectively.
As long as the reserves held by Qatar allow the government to maintain relatively strong spending levels to support real estate and consumer’s ability to service their existing financing, the Islamic banks will benefit similarly to conventional banks. The ability of the sovereign to repay the financing it has taken out from the banks is relatively unquestioned (and since almost 90% of banks’ financing assets are domestic, and probably all QR-denominated, it should remain so).
The same is not necessarily true for financing tied to real estate (whose values can swing rapidly—witness the U.S. from 2007-2009 or Dubai from 2009-2010) and consumer financing and non-performing financing in these sectors would be the catalyst for underperformance by Qatar’s Islamic banks relative to their conventional competitors.