Uncertainty about Malaysia’s troubled quasi-sovereign fund 1Malaysia Development Berhad (1MDB) rose during the week as the Attorney General, who replaced a predecessor who was removed in July, declined to push forward with charges against anyone involved in the fund. The central bank, meanwhile, decided that unspecified investments abroad by 1MDB worth a combined $1.8 billion had violated foreign exchange laws because of inaccurate or incomplete disclosures and would need to be reversed. The Ringgit gained over 5% on the week closing at 4.135 to the dollar, in line with other emerging market currencies as the dollar weakened.
Islamic Leadership in Emerging Markets
By Kurt Lieberman, CEO, Magni Global.
Most discussions of Islamic Finance focus on substitutes for debt and overcoming the prohibition on riba. When Islamic Finance discussions turn to equities, the focus is usually on Shariah compliance of individual companies and investment products built on portfolios of Shariah-compliant companies. An important financial discussion not being held is about leadership by Islamic countries.
Currently there are six countries within the emerging markets where a majority of citizens are Muslim: Egypt, Indonesia, Malaysia, Qatar, Turkey, and United Arab Emirates. Can one or more of these countries become a clear leader in the world? Upon examining the data, the question is not whether, but when.
Two sets of data are very enlightening when doing the examination. The first involves the relative performance of the equity markets in the countries of the emerging and developed markets. The second contains the widely-accepted economic concepts on the role of countries on company valuations. The legal and regulatory system of a country, along with its economic infrastructure, create an environment for corporate governance that is used by the companies within the country. Magni Country Scores measure the respective country’s environment for effective corporate governance. Portfolios built on these scores have outperformed relevant benchmarks over extended periods.
As a group, the long-term performance of the six Islamic countries has been slightly better than the ACWI ex-US benchmark. This strong performance is probably surprising to many investors and deserves greater attention.
An equally weighted portfolio of MSCI Egypt GR USD, MSCI Indonesia GR USD, MSCI Malaysia GR USD, MSCI Qatar GR USD, MSCI Turkey GR USD and MSCI UAE GR USD compared to MSCI ACWI ex-US for five and ten year periods ending 6/30/15 respectively showed outperformance of 54 and 75 bps per year. ACWI ex-US comprises 45 countries which represent all of the countries in the emerging and developed markets with the exception of the United States.
Even more surprising is that this performance occurred despite the six countries having material weaknesses in their respective environments for corporate governance. Specifically, all of them have below average Magni Country Scores when compared against the 45 countries in the same international benchmark. Only Indonesia and Malaysia score higher than the average for the countries in the emerging markets.
Looking forward there is good news. Over the past year these six countries improved their environments for corporate governance faster than the other major countries in the world. Should the relatively faster pace of improvement continue, the Islamic countries will improve their ranking and probably begin to be recognized as leaders among the countries in the emerging markets. Further, one of these countries could soon overtake Ireland which is currently the lowest ranked country in the developed markets.
The six countries share some common strengths and weaknesses in their environments for effective corporate governance. The financial statements of public companies in these countries have similar reliability and accuracy in representing the actual operating performance when compared to other countries. Further, some key shareholder property rights are protected as well as these same rights are protected in other countries. Such rights are established and enforced by the laws and regulations related to corporate legal entities.
At the same time, the countries have some common opportunities to improve their environment for corporate governance and hence to improve their Magni Country Scores. Strengthening financial systems are important as they help reassure investors that their property rights to future profits are protected from corruption. Increasing governmental transparency, especially related to monetary and fiscal policy, would reduce uncertainty and enable businesses to invest capital more confidently (i.e., reduced risk discount applied to investment proposals). Egypt, Qatar, and the United Arab Emirates could also improve the accuracy and completeness of economic and other information published by their respective governments. Collectively, such improvements would have meaningful impact on each country’s ranking.
Fortunately, these improvements are consistent with Islamic values. Strengthening banking regulations and payment systems increase Amanah (trust) in the financial system. Increasing governmental transparency increases Adl (justice) and reduces the potential for transactions involving Gharar (“deceptive uncertainty”) as parties to transactions are dealing with comparable, accurate information.
By the end of this current decade, the world may be talking about one or more Islamic countries as leader(s) among the countries of the emerging markets.
Magni Global Asset Management is the leader in measuring country-level governance and has more than fourteen years of history researching countries based on widely accepted economic concepts. They have published a white paper entitled “Country Selection – A Powerful Technique of International Equity Investing” available for download at www.magniglobal.com/white-papers
Oman’s Islamic banks could provide enough demand on their own for OMR 200 million offering
Oman’s debut sukuk offering is open for subscriptions through October 22 so it is not yet clear what the level of demand will be for it, but it is possible to look at the potential size of buyers for the sukuk. The government has made it clear that the current sukuk will be prioritizing local issuers. The Central Bank of Oman’s Director-General of Budget & Contracts Tahir Salim al Amry told the Muscat Daily that “The sukuk is primarily aimed at addressing the need of the nascent but fast growing Islamic financial sector in Oman. The sukuk will serve as a domestic investment and liquidity management instrument to Islamic financial institutions in the country”.
This was further reinforced by the selection of Bank Muscat and its Islamic banking service Meethaq as lead managers, with Standard Chartered, for the sukuk. Standard Chartered was likely added based on its experience in sovereign sukuk having been involved with many including Hong Kong, Pakistan, Malaysia, Indonesia, Sharjah, Turkey, Qatar and Bahrain. Despite the inclusion of a global bank as an arranger, there will likely be more than enough demand locally for the sukuk to be healthily oversubscribed if only the Islamic banks and Islamic banking services subscribed.
To estimate the potential demand, we compare conventional banks with Islamic (standalone) banks and Islamic banking services. To estimate the potential pool of assets available, we look at three things: cash plus deposits with the central bank, government bonds and other securities held. These are all substitutes for government sukuk. Adding the three together, Islamic banks and windows in Oman have lower combined levels than conventional banks. That means their holdings of other securities besides cash is lower by an amount enough to more than offset their 3.3% higher cash and deposits with the central bank.
If Oman’s Islamic banks were to raise their overall holdings of cash and similar liquid assets (tradable securities including government bonds), it would create RO 138 million in demand for the sovereign sukuk, almost 70% of the reported issuance. Some of this demand will come from Islamic banks lowering their cash and equivalents level.
A 5-year sovereign sukuk is not a perfect substitute for cash and equivalents which requires maturities to be under 3 months, unless the government determines that it would be both repo-eligible (and could provide a Shariah compliant repo facility) and will be classified as a high quality liquid asset under the Basel III rules when they are implemented through 2018 (i.e. before the sukuk matures). If Islamic banks did not believe the sukuk would be a substitute for cash, it would reduce their demand for the sukuk by about RO 60 million.
However, offsetting this would be a possible preference for Islamic banks to buy the sukuk also to generate yielding assets with counterparty exposure to the sovereign because of its low risk-weight. Conventional banks in Oman have 7.2% of their assets to public sector entities, compared with just 0.6% at the Islamic banks. To raise their exposure to the sovereign to the same level as at conventional banks would require an addition RO 121 million, bringing the potential demand for the sovereign sukuk to RO 259 million, or 130% of the anticipated size of the debut sukuk.
Oman’s sovereign sukuk will likely see other investors besides just Islamic banks subscribe, but there is healthy enough potential demand from Islamic banks and Islamic banking services to cover the anticipated size. As a result, it would not be surprising to see the sukuk size raised as the bookbuilding process continues, notwithstanding the reduced liquidity available within Oman as a result of low oil prices. If the government determines not to increase the size of the sukuk, Oman could use the likely highly oversubscribed sukuk as the start of regular issuance to cover rising deficits caused by lower oil prices. In an article earlier this year, Finance Forward estimated that Oman could, unless oil prices recover or the government reduce its spending levels, have up to RO 1,350 million in sukuk outstanding by 2020.