Being the birthplace of Islam and custodian of two of the holiest shrines in the Arab world, it would only be fair to assume that Saudi Arabia would be a natural hub for Islamic finance. Islamic Finance Asia discovers why Saudi Arabia has not emerged as the market leader.

With a burgeoning population of over 25 million – all of whom are practicing Muslims – Saudi Arabia immediately becomes a natural candidate as an Islamic finance hub. Factor in a GDP of an estimated US$581.3billion, 25% of the world’s proven oil reserves, and its position as the largest petroleum exporter in the world, Saudi Arabia is provided with a natural gravitas within the Islamic finance industry.

With oil prices gaining steadily over recent months, hitting fresh highs helped by forecasts of strong demand from developing nations. A return to normal levels of oil revenue will offer Saudi Arabia a comfortable cushion of available capital with which to invest as oil revenues provide 80% of Saudi Arabia’s budget revenue, 45% of its GDP and 90% of its export earnings.

This oil revenue also guarantees a degree of infallibility for investors helping to mitigate investment risk, safe in the knowledge that a reserve of available funding exists should the need arise. This was most effectively shown by the Saudi Arabian authority’s ability to publicly undertake the world’s largest stimulus package by GDP, enabling them to emerge out of the debt crisis quickly, and relatively unscathed.

Growing conscience
This is not to say that Saudi Arabia is a minor player within the Islamic Finance Industry. In February 2009 to February 2010, Saudi Arabia led the GCC with US$5.6 billion in Sukuk issuances. Although not a headline grabbing figure in itself due to the year-on-year disparity, it still demonstrated investor confidence in Islamic financing amid the economic turmoil.

Tariq Al-Rifai. Director of Islamic Indexes at Dow Jones, stated: “Because of the size of its economy, Saudi Arabia will become a natural focus point for the region, and overall, in a region of more than a billion and a half in population, the majority of whom are Muslims, demand for Islamic products will grow.”

He continued: “All eyes are turning to Saudi Arabia where the King Abdullah Financial District has been developed as an attempt to open up a market which is difficult to operate.” Recently published figures in the United Nation’s ‘Ease of Doing Business Report’ further suggest that this trend is being addressed within the kingdom. Reliance on foreign expertise has been a continual trend for the kingdom and one that it hopes to reverse in order to stem growing levels of unemployment.

Investors who are constantly seeking higher returns on their investments – a fact that does not play to the strengths of Islamic finance – is one of the reasons behind the minimal investment total designated to Shariah compliant products in Saudi Arabia. Investment return from conventional financing still proves to be the greatest hurdle for Islamic finance.

This is propagated by the significant wealth disparity within the kingdom, and the fact that the majority of the country’s wealth is the hands of the ruling elite and high net worth individuals have also played a part in the dearth of Islamic investment structures available in the kingdom allowing inherently high risk private equity to dominate the market.

Current concerns
Domestic project finance continues to dominate in the Islamic sphere, with government projects increasingly funded via Sukuk issuances, such as the recent Rabigh Independent Power Plant project, which gained much recognition among the global investment community due to its innovative structure.

However, in terms of market capitalization, Saudi Arabia’s biggest challenger is Malaysia, whose market liberalization policies, innovative products and government incentives have made it the most popular Islamic fund center with 26% of the market share. Malaysia has continually pushed to establish its status as an Islamic financial hub, having to continually innovate to compete with Saudi Arabia’s inherent financial clout.

Investor appeal
Saudi Arabia’s unique tax policies and dominant wealthy Muslim population have also managed to draw in investments from its neighbors. This includes not imposing corporate taxes on local firms but on foreign firms instead. However, if the foreign company is a GCC investor and forms a joint venture with a Saudi company, then the foreign company is only subjected to Zakat taxes, rather than the high corporate taxes.

The emergence of the Islamic bond market in Saudi Arabia over the last two years also saw more asset managers setting up funds in the region. Around 19.6% of the funds were based in Saudi Arabia because of the recent growth of interest in retail funds coming from consumers and from the wealth derived from high oil prices.

Saudi Arabia is expected to make a bigger impact in the realm of Islamic finance over the course of the next few years in terms of the amount investable capital it can bring to the Islamic financial market, thus fuelling the continual growth of this nascent industry.