Global Growth of Islamic Finance and Policy Challenges
Jikon Lai urges policymakers wishing to have a hand in shaping emerging trends to consider embracing Islamic finance or risk being left behind the curve.
As the size of the global market for Islamic finance has grown, so has interest in the sector. Unsurprisingly this is motivated by potential economic gains. The sector has been growing at exponential rates with the overall size of the Islamic financial industry increasing from $80 billion in 2000 to $1.1 trillion at the end of 2011. With only about 12 per cent of the world’s Muslims currently using Islamic finance, the potential for further growth is significant, an expectation that is reinforced by the fact that Muslims make up about a fifth of the world’s population.
The turn towards Islamic finance is also encouraged by the financial instability that began in the US and Europe in 2006-8 and the subsequent contraction of conventional capital markets, which has limited the amount of funding available in such markets. In contrast, banking assets in global Islamic finance doubled in size between 2006 and 2011, despite the global financial crisis.
Despite the enthusiasm, most countries, in particular non-Muslim majority ones, have struggled with trying to develop their own Islamic financial market in order to tap into the potential economic benefits from this niche sector. This is because developing a local market for Islamic finance is not a straightforward exercise. Due to the nature of Islamic financial products, its development requires legislative and regulatory changes that go to the heart of how modern capitalist economies are configured. For non-Muslim majority countries, the difficulty of addressing these changes is compounded by political opposition to the adoption of Islamic elements into the economy, as well as the uncertainty over the potential future economic benefits of developing Islamic financial markets. While it is understandable that policy-makers would be deterred by these challenges, it would be shortsighted to give up on Islamic finance at such an early stage. I elaborate these points in the remainder of the column.
The Challenge of Developing Islamic Financial Markets
Developing a domestic Islamic financial sector is not a simple matter of devising a product, introducing it into the market and then expecting it to thrive. Although financial products in Islamic finance are functionally equivalent to those in the conventional sector, the way in which they are structured and manifested is sufficiently different that they will be less competitive than their conventional counterparts (and hence financially less attractive) if they are sold within existing legal and taxation systems that have been built around conventional finance.
In general, a number of Islamic financial products require multiple transactions (more than their conventional counterparts) to achieve functional equivalence. They are therefore subject to additional tax burdens under most existing legal and taxation systems (recent articles by Kerrie Sadiq and Ann Black; and Salim Farrar, among others, discuss these differences in greater depth). Furthermore, the legal definitions of types of financial products in some countries cannot currently accommodate Islamic financial products if they are to have any legal effect. For example, the legal definition of financial bonds frequently includes references to interest payments that are prohibited under Islamic finance. As such, countries that wish to develop indigenous Islamic financial markets find themselves having to consider tax and regulatory changes. At the extreme, Malaysia, a widely recognised global hub for Islamic finance, amended its Central Bank Act to recognise a dual (Islamic and conventional) financial system as well as making numerous other legislative and regulatory changes in order to accommodate this market.
These legal and regulatory changes are no simple matter. Existing legal and taxation systems have been developed over years to support a specific configuration of forms of business and financial transactions and activities. Changing these systems could induce a transformation of existing practices and dynamics, as a recent review of Australian taxation laws has recognized. Some countries such as France and Korea have taken a cautious, minimalist strategy to tweak their tax and regulatory structures at the margins to accommodate a narrow range of Islamic financial products (specifically Islamic bonds known as sukuk). Countries with large Muslim populations, such as Malaysia, have been more willing to make extensive changes to promote a broader development of Islamic finance.
Political Opposition to Islamic Law
While it is possible to approach these changes to national legal and taxation systems in a technical manner, in non-Muslim majority countries the exercise is frequently bound up with political debates, centred around an opposition to sharia (also known as Islamic law that embraces all aspects of Islamic life, including finance). This helps to explain why there has been little progress in the development of Islamic financial markets in countries such as Australia, even though their governments expect economic and financial gains from such a move. Such resistance to the encroachment of Islamic elements into the domestic financial system is fueled as much by a fear of the ‘Other’ as it is a defence of the socio-political status quo.
The case for developing domestic Islamic financial markets in non-Muslim majority countries is also not helped by the fact that its potential economic benefit is, for the moment, largely speculative, and not necessarily very significant when compared with the material benefits derived from the existing conventional sector. For instance, in Australia Muslims comprise less than two per cent of the population and it is, therefore, not clear what rationale exists for creating a distinct if not entirely new financial system to cater to their needs. While it is possible that Australia could attract foreign Muslim-held capital to invest in the Australian economy, it is unclear that this would require the creation of an entirely new market. After all, if investment opportunities in Australia are attractive, you would expect them to be of interest to all international investors – why specifically target religiously-motivated ones?
Finally, despite its exponential growth in recent years, it is estimated that Islamic financial assets currently represent only about one per cent of the global financial system. Despite impressive recent growth rates, there is no certainty that this market will continue to expand at the same pace, nor that it would ever become a significant proportion of the global financial system. Indeed, people in the industry have begun to question the limits of its growth. Moreover, the expected economic benefits rely on best estimates and embody a certain element of speculation or uncertainty.
Unless there is the unanimous political commitment necessary to enact the legislative changes required for the development of a domestic Islamic financial sector, the absence of a clear winning economic argument strengthens the hand of political doubters and stifles market development in non-Muslim majority countries. In contrast, the case of the UK demonstrates how political commitment to maintain London’s role as a leading global financial sector eventually overcame domestic opposition forces to announce the establishment of a special task force in mid-March 2013 to champion London as a global centre for Islamic finance.
A Precautionary Motive?
There is however a possible precautionary argument to throw into the mix.
While it is true that market interest in Islamic finance may fizzle out and that the sector may not turn out to be very substantial, it is also equally possible that it may continue to expand and eventually have very tangible implications for many economies around the world. If the latter were to be the case, we would reasonably expect risk-averse national-level regulators, policy makers, financial institutions as well as the general public to have an interest in the development of Islamic finance, particularly in how it is being structured, regulated and supervised. This is because the experience of recent years has demonstrated that it has become increasingly difficult to contain events in the financial sector within national boundaries.
Although the rules, standards and structure of the global Islamic financial system are presently being discussed and negotiated, at present only regulators and policy-makers from countries with Islamic financial markets, as well as selected international organisations (such as the Bank for International Settlements, IMF etc.), participate in these discussions. If other countries have an interest in being at the negotiating table, it would help to first develop a domestic market for Islamic finance. A decision and commitment to hop onto the Islamic finance bandwagon is therefore not just a matter of short-term material interests, but also longer-term ones. Policy-makers with an eye to the latter should stop prevaricating and move on with the agenda. After all, as history has repeatedly proven, it is far better to have a voice in structuring markets than to later find oneself constrained by prior agreements in which one had no say.
Jikon Lai is a Lecturer in International Relations at The University of Melbourne. His broad research interests include international political economy, the politics of global finance, the political economy of East Asian countries, and issues of economic governance and economic development. He is author of Financial Crisis and Institutional Change in East Asia (Palgrave Macmillan) and has also published in the Asia Europe Journal and the Journal of the Asia-Pacific Economy. Jikon's current research focus is the politics of the global governance of Islamic finance.