Islamic Finance - the IDB Sukuk vs the Dubai Sukuk - Case Study Example

ISLAMIC FINANCE- THE IDB SUKUK VS. THE DUBAI SUKUK Student’s Name Course Tutor Date of Submission Institution Abstract The Sukuk are described by Çizakça (2011, 25) as the equivalent of the conventional bonds. Ideally, they are the Islamic bonds and were designed and structured to help the Islamic faithful from breaking the sharia codes that demand that no Muslim should engage in money lending for the purposes of profit, an activity that is also referred to as the riba. The Sukuk are the representations of undivided shares in tangible assets or investments. In this paper, the IDB Sukuk and the Dubai Sukuk are compared and contrasted in case studies that highlight their structural and functional differences. Overview of the UAE Economy The UAE’s has a GDP of $ 377 b, a GD that has largely been constructed through trade in oil. Averagely, the nation’s annual economic growth, as per the WTO, is 5%, a factor that advocates for the fact that UAE’s economy has multiplied by over 200 its capacity in 1971 at the time of its independence. The nation’s strong GDP has increased the value of investments in assets. Ideally, this factor makes the use of sukuk as an alternative to the conventional bonds a lucrative option for investors (Archer & Abdel Karim 2013, 29). According to Kamso and Ng (2013, 42), the UAE strongly implemented the use of the Dubai Sukuk in 2002 and have since stood to gain as it has become an alternate source of financing for the government’s projects. The graph below indicates the growth and development of the UAE supported through the application of the sukuk (note that the economy grew with an average of $37.5b from 2004 to 2008, a period that is defined by the sukuk’s increased popularity): The Growing Economy of the UAE (Source: Archer & Abdel Karim 2013, 15) The Dubai Sukuk The Dubai Sukuk demands that the investor is issued with a certificate of debt by the issuer in which the issuer’s consent to make principal payments of interest to the investor is indicated. Ideally, this certificate is the representation of the beneficial ownership and interests of the investor in the subject asset (Jonsson 2006, 49). The assets are then rented to the lessee under the Sharia Ijara and the generated returns are given to the investors as the yield of their investments. The principles that guide this manner of operatives are that the Sharia Laws do not inhibit the gaining of yields from investments made in assets (Raei & Kakir 2007, 38). The Islamic Modes of Finance that Underpin the Dubai Sukuk As has already been stated, the Islamic Sukuk was created in compliance of the Sharia Laws that prohibit riba. This prohibition limits the participation of Muslims in financial transactions by stating that the gains from time monetary value are evil (Archer & Abdel Karim 2013, 29). The law reads as follows: “Those who take riba stand as the persons who have been influenced by the devil.” (Raei & Kakir 2007, 38) To the contrary, the law does not prohibit the gaining of profit from investments made in assets. The sharia laws also prohibit the gharar, which is defined as excessive uncertainty. The law stipulates that using money to earn direct yields is comparable to gambling which is an activity that always invokes enmity amongst parties. However, as Oguz Gonulal (2013, 65) described, the prohibitions that have been outlined by the gharar law involves legal trepidation as it does not label commercial gain as illicit. Notably, the sukuk accords the investors with the opportunity to invest in trust assets as an alternative to investing in the conventional bonds as that would be considered as breaking of the law. Investing in the sukuks, on the other hand, is considered as business in partnership (Archer & Abdel Karim 2013, 28). The Dubai Sukuk thereby accord the investors with a partnership in which they earn from the yields that are accrued from assets while the institution, on the other hand, earns from the value of the investments that are made. The Sharia Board Requirements used for the Dubai Sukuk The sharia obligations that have been addressed in the sukuk involve the maintenance of the religiosity levels that Muslims are expected to adhere to. Ideally, the sukuk have been so designed to ensure that no Muslim participates in usury as all transactions should be conducted based on the value and yields that are gained from assets. The board also functions to ensure that the investing Muslims do not participate in the gharar by engaging in activities that are commensurate to gambling (Ali & Vries Robbé 2005, 5). Rating and Investment Considerations The Fitch Ratings Ltd. rates the Dubai Sukuk at an outstanding AA. This is the factor that prompted the increase in the volumes of the issued sukuk to over $10 b by 2010. Nonetheless, there are factors that should be considered by investors before committing their resources to the sukuk. According to Jonsson (2006, 45), the first of the investment considerations that should be made by a Sukuk investor is to address the value of the yields that can be accrued from the investments. Other than that, investors should consider the duration for which they are legally bound and allowed to use and benefit from the Sukuk. The Relevance of Corporate Governance to Dubai Sukuk Ideally, the stakeholders involved in Sukuk have different interests that can override each other. That implies that strategies should be used to balance these interests and to ensure that all the stakeholders get values and yields that equate to their investments. This is the indicator that corporate management and the sukuk correlate and that the features of corporate governance can get used to improve the performances of the sukuk. The Underlying Transactions in the Dubai Sukuk Source: (Tariq 2004, 42) Key: 4: Government Selling Assets 6/8: The SPV issues sukuk certificates to investors 7/5: The investors purchase the assets 2: the SPV leases the assets back to the government 1: The Government pays the SPV for the assets 6: the SPV disburses the interests to the investors in values commensurate to their investments The Risks Associated with the Dubai Sukuk In the instance, the Dubai Sukuk exposes the investors to residual risks. Oguz Gonulal (2013, 75) and Çizakça (2011, 29) collectively explained that such risks can materialize in the events that there are no contractual obligations designed to cover the differences between the principal amounts and the distribution of the accrued sukuk. The risks can also occur in the event that the insurance proceeds are listed under the total loss events of the assets. Mirakhor and Bacha (2013, 90) also opined that the stipulations of the Sharia that demand that financial transactions should be supported by contractual obligations related to a tangible asset can expose the investors to residual risks, especially in the events that mitigating factors do not exist. Other than the residual risks, investing in the Dubai sukuk is always mired in uncertainty with regard to legal resolutions in the event that there result disputes. In his authorship the Islamic debt market for Sukuk securities; the theory and practice of profit sharing investment, Ariff, Iqbar and Mohamed (2012, 152) illustrated what has been considered as the other risk that is faced by Sukuk investors. They explained that the sukuk lack in depth of development of their trading markets. That implies that they are less liquid as compared to the conventional tools. Ideally, most of the Sukuk investments are done over the counter, as they are not adequately listed in organized markets internationally. This challenge develops into a risk as the values of the sukuk barely increase within the expected durations (Ali & Vries Robbé 2005, 5). Nonetheless, the creation has been considered as a success for several factors. According to Ayub (2007, 56), it provided an alternative to Muslims and helped them abide to their beliefs and religious obligations. That is because it encourages their participation in commercial activities that do not involve riba. Besides, the invention has helped to strengthen the Islam nations by creating alternative avenues through which their governments can raise capital for the purposes of development and improving their GDP. Ideally, these benefits resulted into the Sukuk’s high ranking and its increasing use across the globe (Kamso & Ng 2013, 41). Future Sukuk Ideally, most of the lessons that can be learnt from the future Sukuk derive their bases from the risks that have been associated with the bonds (Archer & Abdel Karim 2013, 31). For instance, the issuers should develop the sukuk to limit the differences between the principal amounts and the distribution of the accrued sukuk. According to Tariq (2004, 49), this would be achieved through the creation of contractual obligations that specify that the principal amounts should be proportionate to the distributed yields. Other than that, the issuers should also improve the market presence of the sukuk by increasing their listing on the internationally organized markets (Jonsson 2006, 45). This factor would make the bonds more comparable to the conventional bonds. Besides, it would attract more investments as the values of the sukuk would keep increasing. This would also be in observance of the precepts that were explained by Çizakça (2011, 33) when he explained that international markets always increase the value of investments. The Increasing Demand of the Sukuk Since 2002, the use of the Sukuk has increased in popularity. Ariff, Iqbar and Mohamed (2012, 76) illustrated that it has been adopted in the international trading markets as it is considered as an alternative to the conventional bonds and one that has lesser risks. Other investors, as Oguz Gonulal (2013, 51) explained, also consider that the Sukuk broaden the spectrum of financial management and builds a podium through which the norms of investments in the Western and Muslim worlds can be integrated. The value of the Sukuk in the market has increased to over $120 billion in 2013 since its outright inception in 2002. This is illustrated in the graphical representation below: (Source: Archer & Abdel Karim 2013, 53) The Creativity and Innovation in the Dubai Sukuk The creation of the Dubai Sukuk was based on the fact that the Sharia Laws can get interpreted differently and are still subject to improvements (Raei & Kakir 2007, 38). Ideally, the creators of the bond-type leveraged on the pointer that despite the fact that engaging in direct financial activities for profit is prohibited, the law does not limit the acquisition of assets or the creation of other types of investments that would generate other forms of revenue. The strategy of investing in assets as an alternative to the conventional bonds is, in a sense, the exploitation of the loopholes of the Sharia Laws (Jonsson 2006, 49). That is because it creates a platform through which investors can indirectly lend money to the government and other obligators for profit. Besides, the Sukuk bonds have been designed to have the same value as the conventional bonds, a factor that serves in the maintenance of the level of profitability in the use of bonds (Kamso & Ng 2013, 56). Notably, this innovation can also serve as an alternative to conventional bonds even to the non-Muslims as it encourages the active participation of the issuers in the follow up of the investments. Tariq (2004, 45) whose authorship the Managing the Financial Risks of the Sukuk Structures comprehensively covers the subject stated that the fact that a government can lease its structures and still benefit alongside the investors seems ideal and would be implemented in non-Muslim states. This projection highlights how creatively the sukuk was designed and developed (Ali & Vries Robbé 2005, 5). The IDB and its Role in the Sukuk The IDB is a financial institution that was founded in 1973 by the IOC to finance multilateral developments (Ayub 2007, 56). Ideally, the institution is credited with the fostering of the economic and social developments of the Muslim communities and the member-states. To fulfill the accords of the Sharia Law, the institution meets its obligations to both individual and joint levels within the Muslim Societies. The bank finances its obligations by engaging in an improved type of Sukuk, that which Ariff, Iqbar and Mohamed (2012, 123) described as a hybrid; an improvement of the Dubai Sukuk. The Nature and Structure of the IDB Sukuk In the IDB Sukuk, investors are issued with certificates that represent undivided interests in the trust assets that are otherwise held by the Solidarity Trust Services Ltd; a remote bankruptcy trustee that solely serves the purposes of ensuring that sukuk are adequately and efficiently issued (Archer & Abdel Karim 2013, 29). The certificates earn the investors the rights to earn yields from the ijarah, murabah, and istisna contracts. These contracts are descriptive of the leasing, conditional, and the conditional sale of items (Jonsson 2006, 45). That implies that unlike the Dubai Sukuk that is structured to help the investors earn from rental yields, the IDB Sukuk offers a wider dimension of creating revenue and yields for the investors. The Structure of the IDB Sukuk Source: (Tariq 2004, 67) The Sharia Board Requirements The sharia board in the IDB sukuk has obligations that are the same as the board that is entrusted with the duties of overseeing the activities of the Dubai Sukuk; to ensure that Muslims do not engage in the riba (Ali & Vries Robbé 2005, 6). In the IDB scenario, the board cross-checks to ensure that the stakeholders’ activities are limited to the ijarah, murabah, istisna contracts which create a podium for eraning profit but not through the earning of yields from the direct lending of money, an activity that is considered as sin in the Sharia (Ayub 2007, 56). The Relevance of Corporate Governance to the IDB Sukuk The IDB in itself is an institution that serves the interests of numerous stakeholders Oguz Gonulal (2013, 71). To meet its obligations, the institution has been structured like a corporate institution thereby illustrating the significance of the corporate governance in the maintenance of its operatives. Corporate governance would ensure that the stakeholders’ interests are balanced and that the different types of contracts are adequately handled to ensure that the values of the yields that the investors may get are commensurate to the values of their investments. In a sense, it would serve in ensuring that the IDB Sukuk’s operatives are meted with efficacy (Kamso & Ng 2013, 52). The Creativity and Innovation in the Creation of the IDB Sukuk The IDB is an improvement of the Dubai Sukuk, a fete that was reached by fulfilling some of the limitations of the Dubai Sukuk (Ali & Vries Robbé 2005, 5). To realize this fete, the IDB creatively introduced the different types of contracts through which the Sukuk investors can earn. Ideally, the ijarah, murabah, istisna contracts serve in a wider dimension by broadening the Sukuk. This is factor that also makes the Sukuk more profitable while at the same offering different types of opportunities for the investors. According to Tariq (2004, 51), the IDB recognized that the investors that do not otherwise invest in the conventional bonds always prefer variety and hence accorded them the opportunity to invest in an environment that offers the same. Investment Risks There are risks that are associated with investing in the IDB Sukuk, the first of which defines the interest rate risk. According to Oguz Gonulal (2013, 75), in as much as investors may always target certain levels of interests, the amount of interests tend to be commensurate to the value of the trust asset at the time of the issuance of the interest. According to Mirakhor and Bacha (2013, 92), the assets’ value is influenced by a number of factors that include the standing of the nation’s GDP, currency value, as well as managerial factors. These factors prompt that there is no surety as to the exact amount of interest that may be earned from the asset. The other risk is known as the credit risk, a risk that defines the possible cancellation of the contracts because of the delayed settlements. This implies that there is assurance surety the investor may benefit for the purposed periods. Besides, there are the contracts that may be terminated because of the failure to comply with the Sharia stipulations. Ideally, the sharia board may argue that the manners in which the activities have been operated are not in compliance of the prohibition of the rija and the gharar. The Rating and Success of the IDB Sukuk The Fitch Ratings Company has rated the IDB sukuk at a value of AA. However, the Standard and Poor’s rating Services has rated it at an outstanding AAA. Ideally, these high ratings are the indications that investments in the IDB Sukuk have value and there is probability of regaining the invested subscriptions. This also illustrates why it success because. According to Ali and Vries Robbé (2005, 5), the IDB offers alternative avenues from which investors and lessees can earn without engaging in non-religious activities just like the Dubai Sukuk. However, it is has been considered as a better alternative to the conventional bonds as compared to the Dubai Sukuk because it has a wider podium on which the sukuk operatives can be held. Ideally, the ijarah, murabah, istisna contracts offer different alternatives and even make the sukuk more attractive to both foreign and local investors thereby increasing its profitability (Archer & Abdel Karim 2013, 29). Lessons for the Future IDB Sukuk In future IDB Sukuk should be developed to limit the interest rate risks. For instance, the assets that are chosen for the sukuk should be based in prime areas thereby increasing the likelihood of an increased value as opposed to reduced value (Ayub 2007, 56). Besides, the international listings should be increased to ensure that values of the assets keep increasing or that they do not depreciate. This would ensure that the investors either get the anticipated interests or even better rates (Kamso & Ng 2013, 56). Besides, the Sukuk should be designed to reduce credit risks be ensuring limiting the terms of the agreements and making them easier to meet. This would ensure that no contracts are terminated as the debts will not continue rising (Ariff, Iqbar & Mohamed 2012, 152). A Direct Comparison of the IDB Sukuk to the Dubai Sukuk 1. The Dudai Sukuk Outlook The IDB Sukuk Outlook The investor is issued with a certificate which is a representation of the beneficial interests that they own in a trust asset (the sukuk al ijara) Uses the Ijarah, Murabah, and Istisna contracts 2. The Dubai Sukuk Structure The IDB Sukuk Structure The Lessee sells the assets to the issuer (Sukuk FZCO) which then issues the certificates to investors. The IDB sells portfolio assets under contracts to the ICD which then sells to the Trustee. The trustee then issues certificates of ownership to the investors. 3. Assets Considered used in the Dubai Sukuk Assets Considered used in the IDB Sukuk Land and real estate Land, real estate, manufactured goods 4. Rating of the Dubai Sukuk Rating of the IDB Sukuk AA (Fitch Ratings Limited) AA (Fitch Ratings Ltd), AAA (Standard and Poor’s rating Services) 5. Creativity and Innovation of the Dubai Sukuk Creativity and Innovation of the IDB Sukuk The first alternate to conventional bonds; exploits the weaknesses of the Sharia Laws The varied contracts (Ijarah, Murabah, and Istisna) make the IDB Sukuk more lucrative even that the Dubai Sukuk 6. Risks Associated with the Dubai Sukuk Risks Associated with the IDB Sukuk Residual Risks, Lack of in depth development Interest Risks, Credit Risks 7. Future Expansion of the Dubai Sukuk Future Expansion of the IDB Sukuk Should be developed to have a wider trading approach as compared to using the Ijarah contracts alone; should also reduce the residual risks. Should be developed to limit the interest and credit risks 8. Usage scope of the Dubai Sukuk Usage scope of the IDB Sukuk Majorly used within the UAE Has assumed a more global dimension and its use is quickly becoming popular in other nations 9. Comparability to the Conventional Bonds Comparability to the Conventional Bonds Has a value that can equate to the conventional bonds Its broadened structure and use of various contracts creates a dimension that offers even more opportunities as compared to the conventional bonds Conclusion Ideally, the Sukuk have significantly played the roles of the conventional bonds and even usurped them to some extent. Besides, the Sukuk’s strengths are derived from their advantages, including the fact that they are less complex and have a usage scope that encourages both Muslims and non-Muslims alike to invest in the government. Ideally, the Sukuk users exploit the weaknesses of the Sharia laws and the Sharia Board requirements in not considering that investing in property is an equivalent to investing in conventional bonds. However, the Sukuk’s use has also been buoyed by the positive ratings that it has received on the global scale. References List ALI, P. U., & VRIES ROBBÉ, J. J. D. (2005). 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Singapore: Wiley. MIRAKHOR, A., & BACHA, O. I. (2013). Islamic capital markets a comparative approach. Hoboken, N.J., Wiley. OGUZ GONULAL, S. (2013). Takaful and mutual insurance: alternative approaches to managing risks. Washignton, D.C., World Bank. RAEI, F., & KAKIR, S. (2007). Sukuk Vs. Eurobonds: Is There a Difference in Value-at-Risk?. The IMF, Issues 2237. TARIQ, A. S. (2004). Managing the Financial Risks of the Sukuk Structures. Loughborough University. http://sbp.org.pk/departments/ibd/sukuk-risks.pdf Read More