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Why intra-Islamic trade finance falters

MUSHTAK PARKER looks at some of the constraints on the sector

Considering that intra-Islamic trade between the 57 member countries of the Organisation of Islamic Conference (OIC) states totalled a staggering $556.328bn in 2008, albeit 16.55 per cent of their total trade, one would have assumed that the uptake of Islamic trade and commodity finance would be equally robust.

This is not necessarily so because trade finance in the member countries of the OIC and its organ, the Islamic Development Bank (IDB) Group, remains basic, fragmented, unambitious and constrained by serious political and financial risk impediments and a lack of product innovation, including the take up of export and import credit insurance. The latter is taken for granted in the trade finance culture of the developed countries.

At the same time, Islamic banks remain overtly risk averse and near obsessive about collateral to finance trade deals.

The IDB Group institutions such as the Islamic Corporation for the Insurance of Investment and Export Credit (ICIEC), the Islamic Corporation for the Development of the Private Sector (ICD) and the International Islamic Trade Finance Corporation (ITFC) themselves, while pushing the boundaries of progress and innovation as stand-alone entities, continue to be seriously constrained by a lack of capital and institutional capacity.

The importance of trade finance as an intra-trade, GDP growth and real economy activity is widely recognised by the IDB member governments and the MDB itself. But it is the translation of this recognition into concrete and effective policies and action by the banks that is limiting the scope of the Islamic trade finance sector.

At the 35th Board of Governors of the IDB annual meeting held in Baku, Azerbaijan, this June, IDB president Dr Ahmad Mohamed Ali reiterated that trade financing is one of the important areas of the IDB Group operations, and despite drastic contraction in trade flows at the global level, the IDB Group has remained active in this area.

The cumulative trade financing approvals of the IDB Group, according to Dr Ali, stood at $34.5bn with intra-OIC trade financing representing 75 per cent of this total. Since commencing its business operations in January 2008, ITFC alone approved 133 trade finance operations for member countries amounting to $5.2bn. Dr Ali also commended the work done by ICD in promoting private sector cooperation in this respect and ICIEC through the provision of credit and political risk insurance services, which could not be more important as highlighted by the global financial crisis and economic recession.

As usual, in Baku many of the poorer and developing countries wanted the sky in terms of easy credit and lines of financing from ITFC. But Dr Ali warned that the IDB Group, including ITFC, would have to balance the need to support intra-Islamic trade with “enough guarantees that the ITFC resources would be preserved” and that there would be greater uptake of export credit and political risk insurance.

Over the past few years, trade finance has been neglected by the Islamic financial institutions in order to pursue other types of transactions – private equity, asset management, real estate, Sukuk etc. This despite the fact that these banks often lack the expertise in these areas and usually source-in whole teams to run these departments only to find out down the line that the exercise was a waste of time and resources because the team were not necessarily familiar with Islamic financing structures or the deal flows were limited.

Trade finance supports real trading activity through financing imports and exports, and, therefore, the real economy. The financing is backed by real assets such as receivables whether commodities, equipment and machinery. These can be used as part of an asset pool that can be securitised in the case of a Sukuk issuance. The Islamic Development Bank (IDB), for instance, in its latest $850m Sukuk under its $3bn MTN Programme, used a pool of underlying assets that comprised Ijara (leasing) assets, Murabaha receivables, Istisna receivables and the IDB’s own portfolio of equity and Sukuk investments.

The reality, however, is that Islamic trade finance figures are largely dependent on one product – oil, which inevitably further skews the sector and is unsustainable. As such, there is an urgent challenge for diversified trade, product quality, trade infrastructure, including transportation, communication, information, and credit and financing.

The true state of the Islamic trade finance sector as such is difficult to gauge because of a lack of reliable statistics and data; and poor reporting and disclosure cultures. This is true for both the multilateral development banks (MDBs) such as the IDB Group and for the commercial and specialised Islamic banks.

Yet the few reliable statistics that are available suggest that the potential for Islamic trade finance is huge given that the 56 IDB member countries are some of the world’s largest exporters of strategic commodities such as oil, gas, petrochemicals, palm oil, phosphates, timber, cotton, selected manufactured products and electronics. They are also some of the world’s largest importers and consumers of products such as foodstuffs, livestock, wheat and other soft commodities, white goods and a host of electronic, transport, IT and other machinery and equipment.

The OIC member countries in 2008, for instance, imported $290.328bn worth of goods and commodities from each other, which is only 19 per cent of their total imports. Similarly, they exported $266bn of goods and commodities to each other, which was 14.1 per cent of their total exports.

Murabaha, according to the Bank of London & the Middle East, is a common method of finance in Islamic banking and is a deferred sale of goods at cost plus an agreed profit mark up under which the seller purchases goods at cost price from a supplier and sells the goods to the buyer at cost price plus an agreed mark-up.

Some of the constraints in leveraging intra-Islamic trade finance are:

  • The lack of bilateral or multilateral payments arrangements between IDB member country central banks, which would remove the cost of trade finance and the need to use expensive correspondent banking mechanisms in London, New York, Frankfurt, Paris, Bahrain Kuala Lumpur and Dubai
  • Inadequate trade and financial information flows between member countries
  •  Poor understanding and, therefore, uptake of export and import credit insurance and political risk insurance
  • The risk-averse culture and short-termism of Islamic financial institutions, which are pre-occupied with over-stringent collateral requirements for trade finance deals
  • The lack of product diversification away from vanilla Murabaha (cost-plus financing) mainly using underlying contracts on the London Metals Exchange (LME) and, more recently, palm oil contracts on Bursa Suq Al-Sila Exchange in Kuala Lumpur; and the increasing use of Tawarruq as a commodity Murabaha mechanism
  •  The recycling of Shariah-compliant trade funds, commodity Murabaha funds and structured trade finance funds into the above products
  •  The relatively low incidence of structured trade finance and trade finance syndications, which took a big hit during the credit crunch and the global financial crisis in general
  •  The over-concentration of the use of commodity Murabaha for liquidity management purposes rather than pure commodity Murabaha trade finance. Commodity Murabaha for liquidity management purposes is estimated at $1.2 trillion
  •  Underdeveloped trade statistics and data; and credit and collateral history of companies, SMEs, buyers and suppliers.

However, there have been some encouraging recent developments in the Islamic trade finance sector both in its diversity and scale.

This is particularly evident at the supranational level, where the ITFC, at the Baku meeting, adopted a ‘Road Map for Enhancing Intra-OIC Trade’, which focuses on trade financing, trade promotion, trade facilitation, trade capacity building, promoting and developing strategic commodities originating from OIC Member States.

Dr Ali explained at the meeting that “it is well known that no country or region in the world has grown successfully without large expansion of its trade. For the IDB Group, trade has a very significant importance due to its critical role in economic growth and development. We strongly believe that the said Road Map will help achieve or even exceed the 20 per cent target by the year 2015”.

The figure for last year is about 16.55 per cent. As such, the lack of ambition to boost trade beyond the 20 per cent target by 2015 reveals structural challenges that include the huge disparities between A ‘Road Map for Enhancing Intra-OIC Trade’ focuses on trade financing, trade promotion, trade facilitation, trade capacity building and promoting and developing strategic commodities originating from OIC Member States IDB member countries, which range from some of the richest countries on earth in terms of GDP per capita to some of the poorest according to UN poverty definitions, with over 21 IDB member countries classified as LDCs (Least Developed Countries).

ITFC also partakes in the Aid-for-Trade (AfT) initiative, one of global initiatives aimed at strengthening the capacity of developing countries to participate in and benefit from international trade, offered in co-operation with United Nations Development Programme (UNDP) and United Nations Economic Commission for Europe (UNECE).

In May this year, the ITFC co-hosted the 4th co-ordination meeting for local Arab and Islamic trade finance and trade guarantee institutions with its sister entities, the Islamic Corporation for Insurance of Investments and Export Credits (ICIEC) and the Islamic Corporation for the Development of the Private Sector (ICD).

According to Dr Abdul Rahman Taha, CEO, ICIEC, the meeting was “part of our efforts to identify areas of synergy between the trade finance and trade guarantee entities, which in turn can help the private sector in our member countries to have better access to our products and services; in addition to raising the level of intra-trade and the flow of foreign direct investment (FDI).”

ICIEC is in the process of launching a Letters of Credit (LC) Insurance Fund in addition to its highly successful Documentary Credit Insurance Policy, which it issues to confirming banks in exporting countries. This policy, according to Dr Taha, “enables such banks in say Saudi Arabia, Malaysia and Turkey to accept LCs from countries that are considered high risk, or from banks that are not normally accepted, or accepted but they have small limits.”

ICIEC is now aggressively marketing this product and the potential for the volumes generated are huge. Last year with one Saudi Arabian bank alone, the corporation did close to $500m of business through this product because the bank in question was confirming LCs from oil importing countries. Now banks from Bahrain, Egypt and elsewhere are subscribing to this oil LC product. Given the huge potential, ICIEC is developing the LC Guarantee Fund where both the issuing banks and the confirming banks can invest in this fund.

An important development is the increasing cooperation between ITFC and development funds such as the Saudi Export Programme (SEP), which is part of the Saudi Development Fund, especially in third countries. In Egypt, for instance, ITFC and SEP jointly financed a $100m Syndicated Murabaha Trade Finance transaction to finance the import of petroleum products from Saudi Arabia by the Egyptian General Petroleum Corporation (EGPC).

Ahmed Al Ghanam, general manager, SEP is confident that the above transaction has “translated our MoU (signed in 2009) into a concrete $100m trade finance operation, and also signals a key landmark operation that aims to contribute to the growth of Saudi exports to Egypt on the one hand and also to help further develop intra-trade complementarities between Saudi Arabia and Egypt”. Since the start of 2010, ITFC has approved $368m in trade finance operations for Egypt.

ITFC has also recently completed a $27m “ground-breaking Structured Murabaha sugar trade finance deal” for Indonesia.

In the commercial Islamic trade finance sector, Murabaha syndications and individual transactions, including vanilla commodity Murabaha, LC confirmations and guarantees, continue to flourish albeit in selected markets. Otherwise the business has to be done in cash as opposed to deferred payment terms.

Several recent developments in this respect include the Geneva-based Faisal Private Bank, part of the Dar Al-Maal Al-Islami (DMI) Group, actively building a trade finance arm; Australia’s Westpac unveiling a commodities-based Islamic interbank placement product suitable for Islamic institutions; and Japan’s Nomura Holdings raising $70m in Bahrain arranged in July 2010 through a syndicated commodity Murabaha facility, which was lead arranged by ABC Islamic Bank, the Islamic finance subsidiary of Arab Banking Corporation. Once again, the facility was increased from $50m to $75m due to robust market appetite.

According to Takuya Furuya, chairman Middle East and Africa, Nomura, “the issuance is part of Nomura’s strategy to diversify funding both geographically and by product and comes at a time when we have simultaneously launched a Sukuk in Malaysia”.

Nomura’s debut facility has a three-year tenor and offers a profit margin of 175bps per annum and will be used for general liquidity management purposes. Participating banks included ABC Islamic Bank, IDB, Samba Financial Group, Sumitomo Mitsui Banking Corporation Europe Limited and Ahli United Bank.

However, the trade finance deal that stands out is the $255m dual currency Islamic Structured Murabaha Syndicated Facility (equivalent $121.5m and EUR 99.15m) for Turkey’s Bank Asya, one of four Shariah-compliant participation banks in the country. The deal lead arranged by Noor Islamic Bank, ABC Islamic Bank and Standard Chartered Bank, was – despite current economic conditions – over-subscribed three times and attracted the participation of 26 international banks from across 16 different countries. The fact that the initial amount was $75m – which was then raised to $225m – suggests healthy appetite for Turkish trade finance risk.

Bank Asya’s one-year facility is the first global Islamic Murabaha arranged by any financial institution in 2010 and is also the largest Islamic Murabaha syndication executed in Turkey to date.

The dual currency facility is understandable. Turkey imports in US dollars and exports in the euro because its main export markets are in the Eurozone countries, especially Germany, the Benelux countries, France and Italy.

Turkish participation banks are, perhaps, the most proactive users of Islamic trade finance, which was previously structured mainly through Islamic banks based in Bahrain, but now either directly through Murabaha syndications or through local Turkish banks, including the branches of global majors such as HSBC Amanah, Standard Chartered Saadiq and Citigroup.

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