Banks in the UAE will be much more circumspect in lending and focused on generating cash flow post-crisis, DONNA RICHARDSON discovers.

The notion that Islamic finance was immune to the excesses of the financial crisis has been scuppered by the announcements over Sukuk repayment defaults and at the same time laid bare the soft spots in Islamic finance such as regulation and legal implications in case of defaults.

In light of the announcements, consumer confidence in the region plummeted and the market has yo-yoed. In mid-February the price of insuring Dubai debt against a default rocketed following news that Dubai World may offer creditors just 60% of the money they are owed as part of a deal to reschedule US$22 billion in debt.

At the time of publication, the Dubai government was engaged in tough and prolonged negotiations with international institutions over Dubai World’s debts, and while it may wrangle out a favorable deal for itself this time around, next time once-bitten institutions may very well shy away from lending to the emirate.

Dubai’s arrogance and lack of transparency is hurting not only its relationship with international markets, but is also casting a pall of gloom over the rest of the economy as investors in the Dubai projects include several large western banks. They have been both spooked by the crisis and disgruntled by Dubai’s proposals to date on how to repay them.

Status quo
Mohamed Damak, lead Islamic finance analyst for Standard and Poor’s, said: “In Dubai in particular, I think the uncertainties surrounding how the Dubai World story unfolds will probably make the market access structure much more difficult on an Islamic and market basis.”

The Sukuk were used to finance massive and ambitious flagship projects like the Dubailand theme park, but when these Sukuk were launched, it seemed that investors paid scant attention to how controversies might be resolved. Luckily for Dubai, its elder brother down the street was able to bail it out in its hour of need. Nakheel was able to pay back its Sukuk only in the nick of time after Dubai obtained a loan from Abu Dhabi.

“The Dubai crisis was a serious and unexpected outcome not only for the Islamic segment but for all segments,” said Raghu Mandagolathur, head of research at the Kuwait Financial Center (Markaz). “Its ramifications will be felt across the board for some time to come.
“While Abu Dhabi has restored Dubai’s financial position for the time being, the same cannot be said going forward. Remember, the debt maturities for various Dubai entities would keep coming for the next two to three years and every time Abu Dhabi cannot be expected to pitch in. Hence, Dubai and therefore UAE would remain volatile from a market point of view, thereby constricting the ability of borrowers to raise money through Sukuk.”

The demand for Shariah compliant products is already there in the GCC. However there may be periods of risk aversion like the present that may temporarily suppress demand, especially from institutional investors. “The supply side can be augmented if sovereigns increasingly tap this option and expand the market. Large and growing sovereign issues would enable be able to establish a yield curve and encourage the corporate sector to follow suit,” said Mandagolathur.

That may offer a clue as to why the emirate is playing hard ball with the banks but many do not want to play. According to Arul Kandasamy, head of Islamic finance and investments at Abu Dhabi Commercial Bank: “Regarding the Dubai World scenario, Islamic banks will be impacted in the same way as conventional banks, that is, to the extent they have lent, they will either need to roll over the principal and/or take a haircut, depending on the outcome of the restructuring, which is unclear at this stage.

“Investors are being cautious. Actually, there is very little growth in the region. All projects are on hold in Dubai — and many in Abu Dhabi. Nothing is likely to happen Islamically in Dubai based on the current situation.”

In fact, uncertainty over Dubai’s debts has led to a knee-jerk reaction amongst financial institutions in the Gulf — they are less likely to lend to corporates or will build in greater risk management measures. However, researchers say, it has yet to lead to a contraction of liquidity due to the situation.

“Significantly, there is a risk that this will keep recurring. The Sukuk defaults and near-defaults have created a lot of uncertainty in the markets and highlighted the problem of non-transparency. For Islamic institutions, this has been one the biggest problems in the region because some of them have large exposures to the property sector,” said Jarmo Kotilaine, an economist at NCB Capital.

“There is an additional risk for the Islamic debt capital markets: The crisis has highlighted the fact that we are poorly prepared to deal with Sukuk defaults and has made people a bit more nervous about issuing them.”

However, Damak of Standard and Poor’s said that since the debt announcement by Dubai World, there has not been any material decline in liquidity among the banks of the UAE. “We believe that the access to the banks for financial institutions will become more difficult in Dubai. Also, the support mechanisms that were put in place by the Central Government were not sufficient. We understand that some Dubai-based banks subscribed to the Sukuk but the support that was provided by Abu Dhabi was done on a conventional basis.”

Immune from contagion?
Islamic banks did not suffer directly from the subprime crisis in 2007 since they were prohibited from investing and trading in fixed income products. They are however, just as exposed as conventional banks to the consequences of the economic impact on the GCC. Moreover, money disappeared in 2008. “Liquidity dipped in the aftermath of speculative money which entered the country due to the value of GCC currencies including the UAE Dirham left the system in 2008 and this led to the crisis,” said Damak.

While the western world had Lehman Brothers as the straw that broke the back, being a crisis of confidence caused by inflated liquidity-driven assets, the once superlative-driven Dubai’s crisis is about defaults — the reality is that Dubai World borrowed too much money and couldn’t make the repayments. Elsewhere, toxic Sukuk such as those of Golden Belt and Investment Dar have led to an expansion of confidence issues across the region.

As a result of the crisis, typically central banks and regulators should do a lot more to ensure that Islamic investors are protected in default situations. “Regulators should ensure that all investors are protected in default situations. There should not be any differentiation between Islamic and conventional. Right now, Islamic is ahead in some areas, behind in others,” said Kotilaine emphasized.

Moving forward
Only by diversifying beyond real estate and retail into real economy activities such as aviation, agriculture, food, services, healthcare and education would the risk be reduced and new product development opportunities enhanced. The importance of new product development is essential for the survival of the Islamic finance Industry.

On the Islamic investment banking side — for cash investors — Dar Al Sharia Legal and Financial Consultancy, a subsidiary of Dubai Islamic Bank, is developing a product. Muhiuddin Ghazi, an Islamic product advisor for Dar Al Sharia, said Salam is a derivative of Murabahah and is equity based. Major products will be interrelated to goods and services but customers will be able to buy in cash. Banks will be able to purchase commodities and tangible goods with the terms prepared in advance. After the expiry date, the bank will resell them to the end users.

“After the Tawarruq was rejected by some as not being Shariah compliant, there was no product available in the field for cash payments (to raise short term yield) and this is something we have been working on, a Tawarruq successors,” Ghazi said.