The Islamic Capital Market has seen considerable growth

1. Over the past two decades or so the Islamic Capital Market (ICM) in Malaysia has emerged as a significant area of growth. It has come a long way since the first issue of Islamic bonds by Shell in 1990, the establishment of the first Islamic unit trust fund by Arab Malaysian Unit Trust Bhd in 1993 and the establishment of BIMB Securities, the first full-fledged Islamic stockbroking company, in 1994. The Malaysian ICM today has the full complement of products, infrastructure, institutions, intermediaries and investors contributing to greater depth and breadth of the entire capital market.

2. Today we have 826 Shariah compliant stocks listed on Bursa Malaysia with a market capitalisation of about RM440 billion or 64% of the total market capitalisation.

3. The availability of Shariah compliant stocks has also boosted the development of the Islamic funds management industry. Starting with 2 equity funds in 1993 we now have 77 Islamic unit trust funds comprising both equity and bond funds with a net asset value of about RM6.8 billion or about 8% of the total NAV of the unit trust industry. Over the last 10 years Islamic unit trust funds have been growing at a compounded annual rate of 47% while the unit trust industry as a whole grew at about 9.6%.

4. The same success story can be seen in the bond market. The growth and development of Islamic bonds is also very impressive as we have witnessed significant increase in the size of Islamic bonds issued by corporate bodies. Total outstanding Islamic corporate bonds currently stand at about RM78 billion or 41% of total outstanding corporate bonds. In the first six months of this year, there were 33 issues of Islamic bonds structured based on various underlying Shariah principles including Mudharabah and Musharakah. With total nominal value of just under RM 13 billion, this represents 78% of the total corporate bonds issued in Malaysia during that period.

The objective of effective and efficient mobilisation of Islamic funds has been achieved

5. Clearly we have come a long way since the early days. The efforts of the government over the past decade or so in developing the ICM has shown results. These efforts were initially driven by the specific need to address effective and efficient mobilisation of funds of Islamic banks, takaful as well as other Islamic institutions such as Tabung Haji, and enhancing the liquidity management of these sectors. Today not only has this objective been attained, Islamic capital market products and services have also become part and parcel of the broader capital market landscape in Malaysia, offering viable and competitive alternatives to conventional products and services, hence reflecting their increasing popularity and acceptability both as financing and investment tools.

6. To the extent that early efforts, policies, and strategies were intended to fill a gap and to bridge investors’ faith-based demands for products and services with faith-based business and financial solutions and products, these policies and strategies clearly have been more than successful. There is now a sufficiently wide array of Shariah-compliant products in the capital market to fulfil the needs of investors looking for faith-based investing. We have bonds structured using a variety of Islamic principles, we have Shariah-compliant stocks for direct investment in the capital market, we have unit trust funds for those who prefer the collective investment vehicle. We also have the Shariah Index, we have intermediaries and advisers offering expertise both on the demand and supply sides.

Government-driven policies and initiatives were key to the success of the initial phase

7. These have been achieved through clear policies and government-driven initiatives. The establishment twelve years ago of the SC whose mandate include not just regulating but also developing the market, provided ownership and leadership to the governments efforts to develop the ICM. This statutory developmental mandate enabled the SC to move very quickly to put in place the necessary institutional and regulatory infrastructure for the development of ICM. Significant top-down initiatives were pursued.

8. The establishment of a Shariah Advisory Council for the capital market at the level of the regulator in 1996 provided the single most important impetus for the success of other initiatives. With the SAC presiding as the highest point of reference with respect to all Shariah matters in the capital market, many other building blocks were able to be put in place. The SC’s extensive powers with respect to issuance and offer of securities in the market paved the way for the SC to issue legally binding guidelines and requirements with respect to the Islamic Capital Market. This enabled for instance the SC to impose specific requirements for Islamic unit trust funds and Islamic bonds.

9. The adoption and pursuit of a screening process to determine Shariah compliant stocks, the issuance of numerous guidelines to impose additional requirements on products that are identified as Shariah compliant, the ability to respond to queries and clarifications on Shariah issues from the market, coupled with the SC’s own ability to address regulatory and tax impediments with the relevant authorities and to introduce education and awareness programmes through the publication of resolutions of the SAC and through specific programmes organised by the Securities Industry Development Centre, enabled the necessary building blocks to be put in place.

Taking the ICM to its next phase of development – A strategic shift

10. What then should the focus of the next phase of development be? Where do we go from here? To me taking the Malaysian Islamic capital market to its next level of development requires a strategic shift on several fronts.

11. First, we should move beyond the desire to fulfil the special needs of faith-based investors to providing real and viable investment alternatives to all. Second, the focus of our efforts should extend beyond the domestic market. Third we have to move from product adaptation and imitation to product origination and innovation. Fourth, we have to move from government-driven, top-down policies and initiatives to market-driven efforts. Let me elaborate on each of these.

From fulfilling the needs of Muslims to providing real and viable investment alternatives to all

12. The ICM serves the same economic purpose as the conventional capital market. Hence the ICM must move beyond bridging investors’ faith-based demand for products with faith-based business and financial solutions and products. Universal acceptability, not exclusivity must be the objective and hallmark of ICM going forward.

13. It is a well-known fact that in Malaysia, Islamic banking, takaful and capital market products are beginning to be accepted as viable, competitive alternatives to conventional products. In fact according to an independent survey more than two thirds of financing provided by Islamic banks are to non-Muslims. Similarly more than half of the units offered by Islamic unit trust funds are subscribed by non-Muslims. Similarly the issuance of Islamic bonds by corporations whose financing needs can also be met by the use of conventional instruments and the interest of public-listed companies not belonging to Muslims in the status of their Shariah compliance are testimony to this.

14. In this regard, it is no longer appropriate to talk of the potential market for ICM in terms of the number of Islamic funds, the Muslim population and such narrow parameters. The entire financial system must be the potential for the ICM. The success in “mainstreaming” Islamic products and services in Malaysia, should be replicated on the international front. The potential market for global ICM products is therefore not the often quoted assets of 265 or so Islamic banks worth in excess of USD260 billion, with deposits growing at between 10 to 20% annually, or the total amount of investible funds belonging to GCC countries said to be in excess of 400 billion or those belonging to their high net worth individuals said to be in excess USD 1.6 trillion.

15. On the contrary, the potential global market for ICM products and services is the global financial system. A recent survey by McKinsey &Co estimated the global stock of financial capital available for intermediation stood at USD 118 trillion in 2004 and is expected to exceed USD 200 trillion by 2010. Roughly 80% of the global financial stock is in developed economies like US, Europe and Japan. Today, almost all are likely to comprise conventional products.

16. Hence, the challenge going forward is how to make ICM products the products of choice for all issuers, intermediaries and investors irrespective of their faith. ICM product and services must therefore compete against the best and most competitive in the world, not just against what is offered by other ICM centres. The strategy going forward must be to focus on convergence rather than differentiation; on similarities with, rather than differences from, conventional products. It is therefore imperative that standards of documentation, governance structure and practices, levels of transparency, disclosure, and the protection accorded to investors, are benchmarked against existing international standards, best practices and codes.

From domestic to global focus

17. Looking beyond the domestic market to global market is in fact not a new strategy. It is clearly articulated in the Capital Market Masterplan (CMP). One of the six strategic objectives of the CMP is the establishment of Malaysia as an international Islamic Capital Market Centre. This is because Malaysia has a comparative and competitive advantage with respect to Islamic capital market. Towards this end, the CMP calls for the enhancing of the value recognition of the Malaysian Islamic Capital Market internationally.

18. Among others, specific recommendations of the CMP include enhancing awareness of Malaysia’s Islamic capital market at domestic and international levels. Establishing strategic alliance with other key Islamic capital market centres, issuance of international Islamic bonds by government and government-related entities and the possibility of listing Malaysia funds in the international market.

19. Some of the specific initiatives that are being pursued in the attainment of this initiative is to continue the path of developing more universally acceptable Shariah compliant products.

20. Of course fundamentally and at the most basic level this calls for the adoption of Shariah principles that are universally acceptable. But that is not all. As mentioned earlier, standards, practices and documentation must also be internationally benchmarked. Product developers, issuers and advisers must ensure international acceptability and compatibility through benchmarking against international best practices and standards such as IOSCO’s Objectives and Principles of Securities Regulation and OECD’s Corporate Governance Principles. Furthermore the listing of products on the international exchanges will enhance investor access to those products and facilitate the participation of conventional issuers and investors, thus further facilitating the integration with the global financial system.

21. The best way to achieve the above is to allow our products to be offered to investors across the globe and to open our markets not only to foreign investors but also to foreign issuers and intermediaries. The more diversified the issuer and investor base, the further ICM products move up the ladder of international compatibility, competitiveness and acceptability. In this regard, Malaysia’s global sovereign sukuk in 2002 – the world’s first – is a fine example. Facilitated by local and international intermediaries, this issue achieved by way of geographical distribution of investors, 51% from the Middle East, 30% from Asia, 15% from Europe and 4% from the US. On the flip side we have more recently seen the issuance in Malaysia of ringgit denominated Islamic bonds by supranationals, again facilitated by local and international intermediaries. These again attracted both local as well as international investors. In this regard, the involvement of global issuers, investors and intermediaries in the ICM will ensure that these goals are achieved, as they would demand standards of compliance, transparency and governance that they are familiar with and accustomed to. The licensing of foreign Islamic banks, foreign stockbroking and fund management companies will all contribute significantly to the achievement of this goal.

22. Recent liberalisation measures that were announced by the SC are also expected to facilitate cross-border issuance and investment including with respect to ICM products. The liberalisation measures among others, allows non-ringgit bonds to be traded in Malaysia without SC’s prior approval if traded between sophisticated investors. Malaysian PLCs are also allowed to issue non-ringgit bonds to sophisticated investors in Malaysia. Additionally Malaysian investors can now invest in foreign securities listed on recognised foreign exchanges while offering of foreign shares is allowed subject to SC approval. While these measures are not targeted specifically to ICM, it is expected that they will go a long way in helping promote ICM internationally.

From product adaptation to product origination

23. There is nothing wrong with adaptation and imitation. It is our willingness to unravel conventional products and structures and address those portions that are not Shariah compliant that have brought success to the ICM in the first phase of development. In fact to do otherwise in the first phase of development may not have been possible as investors would want to invest in products with which they have a certain degree of familiarity and comfort. But to continue to do so would mean that ICM would always lag behind the conventional market. It would also mean that the richness of Shariah principles will never be fully utilised or tapped.

24. Product origination and innovation however cannot take place if ICM products must continue to fit into conventional regulatory straight jackets. Our experience with respect to Islamic bonds is a clear case study in this regard. As some of you may be aware in our effort to facilitate product innovation in ICM, the SC released the Guidelines on Offering of Islamic Securities in 2004. This Guidelines introduced an umbrella framework for Islamic securities, enabling and facilitating the development of a more innovative and sophisticated ICM.

25. Prior to the issuance of these Guidelines, the issuance of Islamic bonds was subject to the guidelines for the issuance of conventional bonds, subject to appropriate modifications, particularly in terms of the requirements of Shariah adviser etc. Conventional bonds as we all know are based on the legal concept of debentures, which involves element of indebtedness. Hence this had a limiting effect on the development of Islamic bonds based on structures involving elements of equity participation like Musharakah (profit and loss sharing) and Mudharabah (profit sharing) bonds. Hence the issuance of Islamic bonds were then confined to those based on BBA (deferred sale) and Murabahah (sale and purchase transaction involving cost plus profit margin) principles. This had a constraining effect on the growth of the Islamic bond market. The introduction of the Islamic Securities Guidelines and some changes to the definition of securities in the law, effectively de-coupled Islamic bonds from the definition of debentures and allowed issuers to structure products based on the very rich fiqh muamalat principles.

From policy-driven to market-driven initiatives

26. The ICM is no longer in the construction phase. The building blocks are all in place – the institutional and regulatory framework, the market infrastructure, the tax incentives and indeed the long-term policy direction. Of course the government will need to address residual legal or tax issues and fine-tune existing frameworks to ensure relevance and effectiveness. The global market is now convinced of favourable policies and facilitative framework for Malaysia’s ICM. What they need to see is more innovative products originating from Malaysia and marketed to the world. What they need to see is Malaysian intermediaries offering their ICM skills and expertise to the global financial community. While it has to be acknowledged that even in the first phase this was beginning to happen, more needs to be done. Hence the focus of efforts in the next phase must be largely industry-driven. Product innovation, ensuring global compatibility and acceptance, branding and profiling and promotion must be pursued by the private sector. In the Islamic equity market for instance, a financial intermediary in Malaysia has developed a specialised product to meet the specific needs of their investors and clients in the form of the RHB-Dow Jones Islamic Index which was launched several months ago.

27. Targetting beyond meeting the needs of faith-based investors means ICM products can no longer wait to be bought, they must be sold, and sold aggressively. In this regard, strategic cross-border alliances by our market intermediaries and institutions as well as the direct participation of Malaysian intermediaries in some foreign markets will greatly contribute to achieving international presence for Malaysian ICM products and services.

Key Challenges

28. What are some of the key challenges in taking the Malaysian ICM to the next phase of development? First, the need to ensure greater convergence on Shariah matters. Second, ensuring compliance with internationally acceptable standards. Third, ensuring availability of appropriate human capital. Fourth, the need for greater international cooperation and coordination.

29. A lot has been written and said about the need for greater Shariah convergence and this is also a matter being addressed at the international level. Clearly the realisation is there and increasing acceptability of particular products by investors in various part of the world is testimony to the fact that that there has been some progress in the process. With more regular dialogue and discussion among international Shariah scholars not only among themselves but also with academics and capital market practitioners, with efforts being pursued by the likes of IDB and with the growing demand for ICM products that are globally acceptable, we should be able to see greater convergence in the near future. Where complete convergence cannot be achieved, there must be greater tolerance and appreciation of differences in Shariah interpretation.

30. Efforts in ensuring Shariah compliance must be complemented with efforts to ensure international acceptability and compatibility through benchmarking against international best practices and standards such as IOSCO’s principles and objectives of securities regulation, OECD’s Corporate Governance principle and international accounting standards. In this regard, the significant efforts of organisations like IDB, IFSB and AAOFFI cannot be over-emphasised. However at the end of the day, the key driver for this is the need to attract global investors and global issuers.

31. Human capital is pivotal in taking the ICM to its next phase of development. There is a great need to enlarge the pool of human capital in areas like Islamic and conventional finance and specialised tax, legal and accounting expertise. In this regard, market professionals must complement and support the efforts of organisations like SIDC and IBFIM.

32. For the ICM to make significant headway in the global financial system international cooperation and coordination is vital. In this regard, the efforts of IDB in formulating a 10-year Masterplan for the ICM is a good start. Furthermore, where appropriate we can emulate efforts that are currently being pursued in the development of the conventional capital markets by various regional groupings and agencies such as the ADB, the ASEAN+3 Bond Market Initiative as well as the APEC and ASEAN Finance Ministers’ initiatives with regard to capital markets.