The middle east and especially the Persian gulf states are overflowing… with more than just oil, but with investment opportunity.
In fact, in many gulf states oil revenue makes up one of the smallest percentages of GDP. In the United Arab Emirates, for instance, revenues from oil account for just 7% of GDP, beaten by real estate and construction (22.6%), international trade (16%), entrepot warehousing and transhipping (15%) and financial services (11%).
Today, the UAE is better known for its luxury real estate, luxury vacations and tourism, luxury shopping… just about anything luxurious, really. As its second largest emirate, Dubai, continues to grow as a major hub of transcontinental flights, the entire Persian Gulf region will steadily open itself up to more and more western and eastern investment.
As economic ties between Western and Arab economies continue to strengthen, Western investors will hear more and more about a distinctly unique investment vehicle known as sukuk.
Not quite a bond and not quite a stock, sukuk are a rather unique hybrid between the two. As such, they can prove themselves to be some of the most stable investment vehicles anywhere.
Sukuk – A Hybrid Investment Vehicle
To understand what sukuk investments offered in Muslim economies are, we need to first understand what they are not. They are not stocks and they are not bonds – as westerners know them, anyway.
Stocks are equity-based, where the buyer of a stock owns a share of the equity of a company. In this case, the investor owns a portion of the issuer’s net assets. The investment’s value increases or decreases according to changes in the underlying asset’s value.
Bonds, on the other hand, are interest-based, where the buyer of a bond effectively lends money to the issuer in exchange for a known rate of interest. In this case, the investor owns a portion of the issuer’s debts. This investment increases or decreases in value according to changes in interest rates.
While Muslim economies do permit their companies to issue stocks which function the same as they do in the west, they do not permit the issuance of bonds, as the earning of a fixed amount of interest on money lent to another party is considered usury.
Why is usury so detestable? Because in all practical purposes, the lender gains money not from work or production, but from other money. A lender collecting interest isn’t really working for his gain, and isn’t producing anything for his profit.
This is actually a very interesting law, since it encourages industriousness throughout the economy. Under such a law, the only way anyone can make money is by working for it – either producing something, cultivating something, or trading something – and thus contributing to the region’s productivity.
The law not only promotes productivity but also prevents the spontaneous creation of wealth or value at the expense of others. For instance, just the tweaking of the interest rate on a loan can arbitrarily transfer a great deal of extra income and wealth to the lender with the stroke of a pen. This makes it way too easy for large money syndicates to virtually enslave an entire city by collectively agreeing to raise interest rates across the board.
Laws against usury, therefore, are designed to prevent lenders from fattening themselves up at the expense of those who work. In such a society, anyone who wants to get rich has to work for it just like everyone else.
Yet the more integrated the global economy becomes, the more such Muslim nations will encounter foreign investors who prefer to earn a fixed rate of return on their investments. These investors don’t want another company stock which may or may not rise in value. They want a steady rate of return on their investment, something consistent, which only interest-based bonds can offer.
The solution is the creation of sukuk, a hybrid of sorts between asset-based stocks and regularly-paying bonds.
Sukuk – Stronger By Design
Similar to company stocks, sukuk represent part ownership in a property, business or other asset. Thus, the investor buying sukuk is not buying debt, but is buying a physical, tangible asset which generates income.
As part owner of that income-producing asset, the owner of sukuk is thus entitled to part of the profit generated by the asset. So far, it sounds a lot like a common stock, doesn’t it?
The difference, though, is the amount of profit that is paid to the sukuk holder and its frequency. There is nothing in Islamic law which specifies how much of the asset’s profit should be paid to an investor, nor on what time-scale, giving issuers of sukuk a good deal of flexibility in structuring their hybrid equity-based bond.
For instance, a property developer would offer investors a percentage of the rents that will be collected from the property once it is completed. The percentage of the rents could be altered according to changes in the rent collected over time, all-the-while ensuring that the sukuk holders receive a return on their investment that is comparable to prevailing international benchmark interest rates.
While this may seem to westerners like just a masqueraded bond, there is a clear distinction in that the income paid to the investor is derived from a business activity which is in turn based directly on a tangible asset – which the investor owns a portion of.
This now sounds similar to an equity-based stock that pays a guaranteed dividend from the asset’s activities, doesn’t it?
We’re getting closer, but there is still one major difference between a sukuk and a dividend paying stock: At the end of a sukuk’s term, the issuer will buy it back and return the principle to the investor; in doing so, the issuer is not buying back debt, but is buying back an asset. A company stock, on the other hand, does not obligate the issuing company to buy back shares from shareholders, who must in turn find other investors to sell to should they wish to dispose of them.
Yet there is one other important aspect of sukuk which makes them invaluable to Muslim investors in particular… they are issued only in ventures that are acceptable under Islamic law. Any practice foreign or domestic which violates such religious laws – including gambling, adult entertainment and other vices – cannot issue sukuk. A sukuk assures Muslim investors that such an investment conforms with Islamic values and principles.
Asset-Backed Stability
That sukuk are based on tangible assets rather than on mere debt can actually go a long way toward preventing major market upheaval as western economies recently experienced in 2008-09.
We already noted above how bonds allow individual lenders to create wealth virtually out of thin air simply by increasing the interest rate. Apply that on an institutional-scale and you have the making of credit bubbles that were at the heart of the last financial crisis. Wealth created so easily on paper can evaporate just as easily too. And when it does, it can fall so hard it ends up taking down even equities that are based on hard assets.
But because sukuk are not based on debt but on hard assets, there is really only a limited supply of sukuk that can be issued. Wealth is thus not created out of thin air, but is derived from something that exists, from something that is productive.
Naveed Mohammed, Chief Editor of Sukuk.com compares the pitfalls of the western debt-based bond with the advantages of sukuk:
“The practice of profiting from money alone, at the expense of productivity and real people has been one of the drivers for many of the economic problems that have plagued the world in the last decade,” he outlines the sometimes disastrous consequences of deriving income from debt. “Interest and artificial inflation of prices based on debt rather than on real value is the main reason why bubbles form, burst, and then lead to recessions and depressions.
“Sukuk, unlike bonds,” he contrasts, “are priced according to the real market value of the assets that are backing the sukuk certificate… The sale of a sukuk on the secondary market is simply the sale of ownership in the asset.”
That last point is rather significant, as it limits the propagation of bubbles. While most sukuk are bought-back by the issuer, some of the higher rated sukuk can be traded amongst investors on the secondary market. However, even when sukuk exchange hands, what is being traded is a finite, limited asset that is physically stationed somewhere in the world. As such, no new asset is being created in the marketplace, preventing bubbles from running amuck.
True, there do arise inflated property bubbles in Muslim economies as well, which can and do deflate just as in the west. However, such market turbulence is not amplified by sukuk as it often is by debt-based instruments such as bonds and swaps.
As the global marketplace continues to expand its reach and influence into more varied economies and cultures, I wouldn’t be surprised if some of these foreign investment instruments might not work their way into western investment portfolios and spread their influence in the other direction.
In his ventures across far-flung markets, even Marco Polo realized that knowledge and innovation flow both ways.
Joseph Cafariello
