The emerging economies of BRIC have surpassed their conventional appeal and caught the eye of Islamic investors. CAMILLE KLASS looks at what these markets offer and stand to gain, as well as the barriers they face in developing their Islamic finance markets.

On the global trade front, the four largest emerging economies, BRIC (Brazil, Russia, India and China), currently accounts for around 15% of the world’s GDP. These emerging markets have also seen their global trade volumes expand at an average annual growth rate of between 15% and 25%, far outstripping annual world trade growth of 10% between 2000 and 2008. The concept of investing in emerging markets is a familiar one within conventional financing circles, but it is still fairly new territory for Islamic finance, itself a young industry. However, industry watchers say there is potential worth exploring.

“The emerging market economies can offer investors a number of opportunities both on the equity investment side as well as for debt financing,” said Masroor Haq, head of Middle East and Africa at Moscow headquartered investment services company VTB Capital.

The main draw of emerging markets for Islamic bankers and investors is an abundance of natural resources and infrastructure projects and, in some of the markets, a sizable Muslim population. As many of the emerging markets are still “emerging” and; therefore, not completely developed, infrastructure such as roads, hospitals and plants are still wanting — all of which will require funding.

“These types of government projects lend themselves tremendously to be securitized within a Shariah context,” said Rafael Dalmau of BNP Paribas Investment Partners. “Many investment activities in the emerging markets may fall within the scope of Shariah financial transactions because they represent non-haram (forbidden) activities, they are tied to real economic activity (and) they benefit society.”

Such transactions emanating from emerging market countries would provide a much welcomed geographical and industry diversification mix — a clear positive in the development of the asset class, he added. Islamic finance transactions tend to be centered in the Gulf area and Asia.

“We need to add different projects and geographies and one of the things emerging market countries provides is the real economic activity projects that can be securitized,” added Dalmau. “In other words, they can potentially provide a large inventory of transactions outside the GCC or Asia.”

Mutual benefit

While the opportunities are manifold for Islamic investors and bankers, what’s in it for the emerging markets?

“Normal providers of capital are fewer and a bit more circumspect, so if you continue to need to find funds, then you have to consider tapping a new market,” said Mohd Faiz Azmi, global Islamic finance leader at professional services firm PricewaterhouseCoopers (PwC).

Faiz said emerging markets should regard Islamic finance as “an alternative source of funding” especially as global banks, some of whom were weakened during the recent financial crisis, have less capacity to lend and may be retreating from supporting the emerging markets.

In the current environment where liquidity continues to remain tight, Islamic financing provides a practical solution, given the market’s large pool of tappable assets, particularly in the Middle East. Assets of Islamic banks have crossed the US$1 trillion mark and are expected to grow at a rate of 24% per year to US$1.85 trillion by 2013.

“Oil prices are around US$78 a barrel (as at the 21st June 2010) — anything above US$40 is all surplus in the Middle East,” said Faiz. “Consequently, at the current prices, a lot of liquidity is growing in the Middle East in places like Qatar and Saudi Arabia that has to go somewhere.”

BRIC potential

Among the emerging markets that show the greatest potential for Islamic finance are countries in Southeast Asia, the Middle East, the economies of BRIC, and the countries in the Commonwealth of Independent States (CIS) — especially those that have close ties with an Islamic investor base, industry watchers said. Among them, the markets with large Muslim populations are likely to be the ones to start the ball rolling, they added.

“The countries with a Muslim population can definitely capitalize on their understanding of Shariah,” Dalmau said. “It’s easier to explain in a country, where you already have a Muslim population, what Shariah financing is.”

Within Southeast Asia, Indonesia comes up as the strongest market for developing Islamic finance. Indeed, PwC’s Faiz refers to Indonesia as a “sleeping giant” , as “the attractiveness of Indonesia is a critical mass to play with and economic activity to tap on.”

Echoing the sentiment, Simon Eedle, global head of Islamic banking at Credit Agricole-CIB, said: “Indonesia probably offers the most untapped potential in Asia today with the world’s biggest Muslim population, wealth of natural resources and need to develop infrastructure.”

“From a timing perspective it is probably right, too, as Indonesia moves back towards the international financial community following their isolation after the late 1990’s Asia financial crisis,” Eedle added.

“On the asset management side, the move to a bigger weighting in EM (emerging markets) vs G7 is ongoing, and Russia is one of the primary countries to focus (on),” said Eedle.

In the context of Russia and the CIS, VTB Capital’s Haq said there is interest in structures such as Murabahah and Ijarah as potential modes of financing projects, as well as in Shariah compliant funds, which would focus on such areas as infrastructure, agriculture and natural resources.

No guarantee

Although construction and further development of infrastructure projects in the emerging markets would be ideal for Shariah financing and where focus for both investors and global banks should be, there’s no guarantee transactions will materialize, cautions Dalmau.

“These financing needs have been there for a while but they may not necessarily be addressed by Islamic finance transactions,” Dalmau said. “There are many variables involved, regulatory or tax code issues being two examples.”

Amending regulatory and tax issues to allow Islamic finance to exist is tough even in developed countries where tax and legal systems are already established. They could pose a barrier against further growth of the Islamic finance industry in emerging markets, especially as the stage of development of their institutions may not necessarily be as far ahead as they need to be, industry watchers said.

“In most emerging countries, there needs to be a review of the fiscal and legal environment to ensure that Islamic banking practitioners are not penalized, as opposed to conventional investors,” Eedle said.

The lack of investment grade credit ratings and of a proper understanding of Shariah principles, structures and the implications of a Shariah compliant transaction on tax treatment and financing costs are also tough challenges the emerging markets face. The need to understand Shariah principles and the complexities of Shariah compliant financing is why industry watchers expect emerging markets with large Muslim populations to lead the pack. Despite the interest in emerging markets and their anticipated demand for Islamic finance, pricing is an important component in any transaction. Pricing would also determine the extent to which the markets look to Islamic finance as a viable mode of financing.

“Those institutions needing funding and looking at the Islamic financing route as an alternative would certainly look at the cost — it boils down to pricing in many instances,” said Dalmau. “It’s about the least costly source of financing, and for investors it means the search of robust returns. Where the returns are more attractive, they’d naturally gravitate towards it — the greatest return for the lowest finance cost.”