Issuance of Sukuk and Bonds in Malaysia - Essay Example

? Sukuk and Bonds in Malaysia Introduction Business has transformed with the interests s always being the first priority. It is such concerns that have led to the innovation of Islamic finance. For instance, the advent of Sukuk issuance has revolutionized financial services in economies which are largely Islamic. The growth of Islamic Finance has benefited many economies especially the Malaysian economy. It began with a modest issue of RM 125 Million in 1990 and it has grown to a whopping single issue of US$ 4.7 Billion. The growth in Sukuk issuance in Malaysia can be attributed to introduction of innovative Sukuk products and growing confidence by investors. The following discourse delves into Sukuk issuance with specific focus being on the Malaysian economy. According to Ayub (2009), Sukuk may be defined as certificates of equal value that represent an undivided interest in the ownership of an asset or investment. It should be noted that Sukuk have the benefit of being backed by assets hence they offer better protection to the investors as compared to the conventional bonds. Investors who require fixed investment return with low risk find Sukuk to be an ideal choice (Kuran, 2004). One of the forms of Sukuk is known as the Ijarah Sukuk. This kind of Sukuk is based on letting of property rights for a given property on an agreed price. Sovereign issuers have an inclination towards issuing Ijarah Sukuk on a sale and leaseback agreement for a given piece of real estate. The other type of Sukuk is known as Mudharabah Sukuk. This is essentially an agreement between the investors and managers of capital. These are investment Sukuk that represent ownership of units with an equal value in equity. The holders of such Sukuks own shares and are entitled to the returns based upon the percentage of ownership. The key characteristic of Mudhabarah Sukuk is that the holder of the shares is not given a guarantee by the issuer on the capital and fixed profit but rather, the profit is based on a percentage of the given capital (Muhammad, 2009). Musyarakah Sukuk involves the contribution of capital by two parties to incorporate a common motivation. The issuer contributes a given amount of money to obtain a subscription of a given number of shares whilst the originator may contribute either capital or in kind. The profit is shared in a certain ratio and the losses are shared according to capital contribution. Sukuks known as Istisna’s are used to finance the purchase of a project item. The holder of the Sukuk offers finance for a given project and in turn obtains a title to the asset. The title can be returned to the developer at an agreed repayment methodology. It should be noted that Istisna’s Sukuk cannot be traded in the secondary market. Government bonds are issued by the government in order to finance the projects that they require. One of the key characteristic of government bonds is that they have a set maturity date. This implies that the issuer guarantees to give back the principal amount invested the bond after a certain period regardless of how the investment performs. Government bonds also have interest payments. The interest payment can be on a fixed rate whereby a fixed interest is paid periodically for the life of the bond or floating interest whereby the interest rate is determined periodically. The principal investment repayment is also a key characteristic of government bonds. According to Sharma (2007), “it is an obligation of the issuer to repay the principal amount in lump sum upon the maturity of the bond.”`p. 234. Some bonds also have a call feature whereby the issuer has the liberty to return the bond before its maturity date and be paid a percentage of its principal amount. Once the callable bond is paid, the government stops paying interest on the bond. Government bonds are subject to a given minimum investment and have credit ratings. Bonds are income investment because the issuer pays a certain rate of interest for a given period of time until the bond matures. Bonds are a low risk investment option and generally government bonds are exempt from taxation. Therefore, government bonds are a reliable source of income and they provide liquidity since the bond market is active. It should be noted the bonds provide great flexibility since they can be sold prior to maturity to interested parties at an agreed price (Kerry, 2008). Money Supply Control The process of controlling money supply in an economy is critical to ensure economic stability in the country. Too much money in the economy leads to very high inflation rates whilst very little supply of money to the economy can lead to a crunch in credit availability and thus constrain economic development. Thus, the money supply in the economy has to be kept at an optimum level for a sound economy. One of the tools for controlling money supply is through the regulation of reserve requirements. The central bank can regulate the capital reserve ratios for banks in order to regulate the minimum amount of reserves that a bank must vis a vis customer deposits. Capital reserve ratio requirements affect the potential of the banking system to regulate the money supply in an economy. For instance, if the capital reserve ratio is set at 10% a bank which has received a deposit of US $ 100 can only lend out US $ 90. The borrower who has received US$ 90 may invest the amount in his bank. If again the money is lent out by the bank, the maximum amount that can be given is US $ 81. The banking system can expand the initial investment to a maximum of US$ 1000. On the other hand, if the cash reserve ratio is pegged at 20% the bank can lend out US $80 for an initial investment of US$100. As the process continues, the banking system can expand the initial investment to a maximum of US $500. Therefore, a higher cash reserve requirement implies decreased money available for lending. Mishkin (1999) states that: Whenever money comes into the account of a customer, the bank is obliged to keep a part of the amount as reserves. This puts a lid on credit expansion by limiting the amount of money that goes out in form of loans. Therefore, this affects the money creation process and in the long run affects the economy activity in a given country. This process of regulating capital reserve ratios inherently gives the banks the ability to control money supply in the economy (p. 310). The amount money in the economy can also be manipulated through changes in the discount rate. A discount rate can be defined as the rate of interest that the central bank charges commercial banks that borrow to boost their money reserves. The discount rate is not determined by the market rates but rather solely fixed by the central bank. Therefore, the discount rate is utilized by the central bank to send signals to the financial market on the preferred borrowing trends. If the discount rate is high, the implication is that the central bank wants to discourage spending and vice versa. Consequently, the short term market interest rates follow the discount rates and thus directly impact on the amount of money supplied to the economy. If the central bank wants to bolster the reserves of banks, it lowers the discount rates which encourage banks to borrow and lend more. Open market operations through the issuance of government bonds play a major role in the control of money supply in the economy. If the central bank sells bonds to the public, the money supply decreases. However, if the central bank buys back bonds from dealers, the amount of money supply to the public increases. When the central bank buys back bonds from the market, the bank where the check is deposited will have increase reserves. These reserves can be used to support the issuance of loans hence increasing the money supply. According to Iqbal & Mirakhor (2007), the open market operation has an impact on the monetary expansion since it affects the banks and the public. The bank from which the central bank buys back bonds from may end up having a very high reserve ratio. To remedy this, the bank has to increase its loan portfolio. The availability of loans to the public increases the amount of money in the economy hence leading to high money supply. It should be noted that when a bank makes a loan, there is a money multiplier effect in the economy. This is because once the bank issues a loan, the money supply increases by a larger amount than that incidentally caused by the open market operation. Open Market Operations for Islamic and Non-Islamic Countries Open market operations are the major tools for monetary control in the developed and developing countries in the globe. A central bank can increase or reduce the amount of reserves in the banking system by buying and selling government bonds. The indirect control monetary policy in countries is more effective especially in the present generation whereby the economy is global (Visser, 2009). Open market operations allow central banks the flexibility in executing monetary policies at a proper timing and hence avoid the perils associated with direct controls. In Islamic countries, the economy must be in conformity with the religious guidelines provided in the Quran. It is also necessary that the economic policies help the realization of other socioeconomic goals that are emphasized in Islamic teachings. In the recent past, Islamic banking has grown by double digits especially in countries that are predominantly Muslim. The linkage between Islamic principles and the secular values associated with the global economy has been an issue of major concern. The trends in the Islamic countries point out to an increased uptake of open market operations. For example, the value of government bonds in Malaysia grew at an average of 70% per annum within 2001-2007 (Abdel-Kareq & Richardson). This means that the government significantly invested in bonds and the market uptake was positive. In Islamic banking, the demand for money is majorly due to the need of meeting transactional requirements and other basic needs. Interest is illegal under the Sharia compliant Islamic banking therefore there is little strain in the money supply to the market. The tools for open market trading in Malaysia are the Treasury Bills, Government Investment Issues, Malaysian Government Securities and Malaysian Savings Bonds. It is notable that trading of government bonds has been low in Malaysia due to their perceived low yields (Beck et al. 2010). According to Wilson (2004): The open operations market in Malaysia has been stunted due to weak government policies. The government appoints Principal Dealers who are pre-qualified annually. Principal dealers are given preferential access to the discount window and are in turn expected to sell the government bonds to the larger public. This essentially restricts the uptake of the bonds in the market considering that the principal dealers might not be sufficiently motivated to sell the bonds (p. 3). Suffice to say, the development of open market operations in the non Islamic countries has played a pivotal role in their economic growth. Most governments have moved towards the issuance of repurchase agreements (repos) in cognizance of the recent developments in the financial markets. A repo can be defined as a security to the other with a commitment of buying it back at a specified date. The reverse repurchase agreement specifies that the seller will buy back the security at a higher price. Central banks use repos to fine tune the operations of the money supply. In order to bolster the money supply in a country, the central bank may buy securities from dealers. The dealers are the expected to deposit the money obtained to their bank accounts thus increasing the bank reserves. This has the domino effect of expanding the money supply and thus creating an effect on the economy. Critique of Policies for Money Supply Control The concept of money supply control has generated debate among economists in the recent times. Some scholars argue that control policies have been passed by time considering that we are living a free economy generation. Sole’ (2008) argued that money supply should be controlled by market forces just like other aspects of the liberalized economies. Essentially, the proponents of the free economy propose that a laissez faire approach to money supply is the most relevant strategy. However, other scholars argue that fiscal control is essential in order to streamline economic performance in a country. The regulation of capital reserve ratios plays an important in controlling money supply. The banking system is at the core of the financial markets. Essentially, all formal money transactions have to pass through banking institutions. This means that the regulation of capital reserve ratios has a direct impact on the money supply system. The effect of such regulations has immediate effect on the supply of money to the economy. Nevertheless, the regulation of capital reserve ratios is an interference of the model of free economy. It is inappropriate for people in the government through the central banks to limit monetary rates. This has the undesirable effect of limiting the potential of economy by giving a ceiling on the amount of money that can flow in the economy. According to Mahmoud (2006), controlled economies are not viable given that each country is intrinsically linked to the global economy which is essentially a free economy. The revisions of capital reserves ratio cause uncertainties in the economy. Banks are usually reluctant to offer loans to clients before the capital reserve ratios have been announced. Such uncertainties associated with the anticipation of changes in the rates end up creating periods of low performance of the economy. The control of discount rates is an important aspect in regulation of the amount of money supplied to the economy. Discount rates are the interest rates that the central banks charge other banks that borrow to shore up their capital reserves. The essence of the discount rates is to vary the accessibility of funds available to banks for lending to the public. This method implies that the central bank has direct control of the financial money markets. As such, this is a violation of the free economy model. A free economy should leave the market forces to determine the rates of borrowing and lending without the restrictions of unnecessary policies (Baumil & Blender, 2009). High discount rates discourage banks from borrowing thus constricting the money supply in the economy. On the other hand, low discount rates encourage banks to shore up their reserves and consequently avail more money for the public to borrow. However, the availability of adequate money to lend does not necessarily imply that the public will be willing to take loans from the banks. There are other factors that determine the uptake of loans which might not be within the realms of the control of discount rates. The most implemented money supply regulation strategy is the open market operation. This is whereby the government floats bonds to the public in order to finance projects. When the government sells bonds to the public, the money supply is reduced thus there is less money flowing in the economy. However, when the government buys back the bonds more money is pumped into the economy. The beauty of open market operations is that it is a liberalized strategy that relies on the market forces to determine the direction and amount of money supply. Essentially, the open market operation does not force any policy on the financial money markets. Rather, the government offers an investment opportunity for investors to make a choice. Models of Economic Management The adoption of economic models of management plays a significant role in determining the monetary and fiscal policy of a country. In order for a country to select an appropriate economic model, the country in question has take into consideration its present financial condition and its goals. Economic models vary in application from region to region depending on the underlying principles. Classical model of economic management is one of the models that are applied in some countries. A key concept in the classical theories of economics is that supply creates its own demand. This essentially means that the total value output will be equal to the income generated. In Islamic states, this theory finds application given the fact that Islamic finances prohibit interest. It is therefore plausible that at the basic level, the classical theory holds water in Islamic economies. According to Tripp (2008), classical theory of economics embraces the tenets of Islamic banking since the moral aspects of finances are covered appropriately. However, in non Islamic countries the concept of capitalism and secularism makes the implantation of classical model of management difficult. The concept of microfinance is also important in the economic development of a country. The issue of poverty alleviation is of utmost important especially in the developing countries. Microfinance institutions (MFIs) play an important role in financially empowering the poor and vulnerable in the society. The MFIs usually lend out money to individuals or groups under less stringent conditions but at an interest. However, Islamic Microfinance institutions (IMFIs) do not lend out money at an interest rate since interest is prohibited under the Sharia law. The other difference between conventional MFIs and Islamic MFIs is that in conventional MFIs, there are deductions on the loan amount that is given to the recipient whilst the Islamic finance does not make any deductions. The recipient gets the full amount in this case either in form of goods or as cash. This is line with the teachings of the Islamic faith of fairness and justice in the distribution of wealth. Most of the conventional MFIs target women in the society as they are deemed to be the most vulnerable. However, Islamic MFIs tend to target a poor household since Islam recognizes a family as a unit and therefore assistance is accorded to the whole unit (Barry, 2000). The neo classical economic management models propose that economic efficiency and progress can be achieved by ensuring that there are “free and competitive” markets. The assumptions of neo classical theory is that there are many participants and freedom of entry and exit. This implies that framework governing the markets is liberal and encourages competition to foster growth. In Islamic countries, there is little freedom in the markets since the government controls most of the financial instruments. For instance, in Malaysia the government controls the distribution of Sukuks therefore limiting their uptake. This implies that the threshold for neo classical economic model is not sufficiently met in the context of Islamic countries. In non Islamic countries, the concept of free economy has gained traction over the years given the fact that most economies are liberalized. The government provides favorable rules and guidelines that create an environment that allows for competitive and free markets. The neo classical model lays emphasis self correcting market responses rather than tightly controlled markets. Keynesian model of economic management borrows from both the classical and neo classical models. However, the Keynesian model differs with them in the sense it advocates for a mixed economy that comprises of both the private and public sector. The theory postulates that if individual rational decisions are taken by many people they may end up having a significant effect on the microeconomic level. Active stabilization of policy and investment in infrastructure by the government can help in minimizing the amplitude of the business cycles (Beck et al, 2008). The theory further proposes that interest rates reduction can also play a significant role in pulling out an economy out of a depression. It should be noted that Keynesian theory of economic management is a hybrid of best economic practices and moderation in implementation. Therefore, it is applicable in both Islamic and Non Islamic countries. Conclusion Islamic banking and finance has grown tremendously over the past decade. The unique religious and moral requirements of Islamic finance demand that deliberate measures should be taken to introduce financial products that are not conflict with the religion. Sukuk is one of the most important Islamic financial products. The issuance of Sukuk has grown exponentially especially in Malaysia and there has been remarkable adoption in other countries. The control of money supply is important in an economy to ensure that there is adequate amount of money supplied. 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