Hong Kong steps up effort to target trillion-dollar Islamic finance market

Hong Kong steps up effort to target trillion-dollar Islamic finance market

Hong Kong has already cemented its reputation as an international finance hub in Asia, where investors go to buy or sell bonds, currencies and stocks. But the island is not resting on its laurels.

With an increasing threat from Singapore and other emerging finance centers in the region, Hong Kong is going after the 1 trillion US-dollar Islamic finance market to enhance its image and thwart the ambitions of its rivals.

Analysts applaud the move.

‘As far as further promoting Hong Kong’s role as a key financial intermediary in the region, the move towards Islamic finance is a step in the right direction,’ said Vincent Ho, associate director of Asian sovereign ratings at Fitch Ratings.

With escalating oil prices, cash-rich Middle Eastern investors have become a force to reckon with in the global financial world.

Last month, Abu Dhabi rescued Citigroup Inc (NYSE:C) , the biggest bank in the US, from financial disaster by infusing 7.5 billion dollars in fresh capital in exchange for a 4.9 percent stake in the bank.

The market is abuzz with speculation that more wealthy investors from the Middle East will invest in other cash-strapped financial institutions, which have been battered by losses from unpaid housing mortgages in the US. The crisis that began in the US subprime sector, where borrowers have poor or no credit history, has spread into Europe and some parts of Asia thanks to the popular practice of securitizing those mortgages.

‘Hong Kong is in a good position to attract petrodollars from the Middle East. This money has to go somewhere else. With the US and Europe still battling the subprime crisis, Asia is considered a safe haven for investors,’ said Kelvin Lau, an economist at Standard Chartered Bank.

The China syndrome
Hong Kong’s proximity to China, an emerging global powerhouse that is slowly eclipsing Japan in the region, is its natural advantage.

While Japan is struggling to boost growth, China is under pressure to slow its rapidly-expanding economy, which has grown at a pace of more than 11 percent in the last two quarters, causing inflation to climb to the highest level in 11 years.

Already, Hong Kong has outlined broad strategies to establish an Islamic bond market, the first step in its bid to challenge Malaysia’s dominance in the market.

The Hong Kong government, led by Financial Secretary John Tsang, has visited Malaysia to get a glimpse into how Islamic finance works. Early next year, the government is bound for the Middle East, India and other parts of Asia.

‘Although Islamic financing is a relatively new venture for Hong Kong, we are actually ideally positioned as a platform for investors looking to capitalize on the mainland’s rapid economic growth,’ Tsang said during a UK visit in November.

Tsang described Hong Kong’s decision to lure Middle Eastern investors as ‘another exciting prospect.’
‘Our stable and freely convertible currency, flexible regulatory regime and world class financial infrastructure and settlement systems make Hong Kong an attractive choice for investors from all over the world, including the Middle East. The Islamic financial sector is worth an estimated 700 billion to 1 trillion dollars, and is expected to grow by 15 percent annually,’ Tsang said.

The government has also created a working group with the local treasury market group to help in laying out the foundation for Islamic finance, a spokesman for the de facto central bank said in an e-mailed statement.

The group will study whether the present taxation, legal and regulatory systems may affect the development of Islamic bond market in Hong Kong, he said.

‘We hope the Islamic bonds can be issued in Hong Kong as soon as possible,’ he said but declined to provide a more specific timetable.

Meeting the challenge
But creating a financial haven presents challenges.

Islamic finance is a unique concept. And therein lies the problem.

First, Islamic finance has to conform with the Islamic Law, or Shariah, which forbids the payment of interest and stipulates that income must be derived as a return from entrepreneurial investment.

Second, any investments in companies directly or indirectly associated with alcohol, pork products, firearms, tobacco and adult entertainment are prohibited.

These stipulations may make it hard for Hong Kong, with a small Islamic community, to become a key player in Islamic finance, Fitch’s Ho said.

‘Islamic finance requires a lot of technical knowhow. The observance of Islamic law will be a major obstacle that Hong Kong will have to hurdle,’ said Ho. ‘It will take some time before Hong Kong can do it successfully.’
HSBC unit Hang Seng Bank, the first bank (OTCBB:FRBA) in Hong Kong to launch an Islamic fund, is naturally more optimistic than Ho.

‘Hong Kong is a late comer of Islamic finance as compared to other Asian countries,’ said Rosita Lee, director and head of investment products of Hang Seng Investment Management Ltd.

‘With Hong Kong’s well-established financial and legal infrastructure, and the joint effort of the HK government and market participants to accelerate the pace of development, we are confident that Hong Kong will gradually take up a key role in the global Islamic financial market,’ Lee said in a reply to e-mailed questions.

Checking it twice
Launched in November, the Hang Seng Islamic fund totaled 56.4 million US dollars as of Dec 18, a tiny fraction of the overall market.

Hang Seng is targeting not only the Islamic community but also other investors who ‘are conscious about social responsibilities,’ Lee said.

The bank is also exploring ways to market the product to Middle East investors, both institutional and retail.

Currently, the fund invests primarily in a vehicle with a rather complicated name: the constituent stocks of the Dow Jones Islamic Market China/Hong Kong Titan’s Index.

Simply put, the index represents the 30 largest companies whose operations are in mainland China and Hong Kong and are traded in the local stock exchange.

Given the strict conditions under Shariah, Hang Seng’s Islamic fund has two levels of screening as far as investments are concerned.

‘Firstly, sectoral screening will qualitatively preclude certain kinds of business such as alcohol, pork-related products, gambling, pornography, tobacco, conventional financial services. Then, financial screening will quantitatively remove companies that have high levels of of debt or are sensitive to interest rate changes from the potential investment universe,’ Lee said.

So far, the most popular Islamic credit instrument is Sukuk, derived from the Arabic word Sakk, which means certificate, reflecting ownership in an underlying asset.

According to the IMF, the market for Sukuk or Islamic bonds has grown from less than 8 billion dollars in 2003 to 50 billion in mid-2007.

‘Sukuk provide sovereign governments and corporations with access to a huge and growing Islamic liquidity pool, in addition to the conventional investor base. The structure of Sukuk is now well established in several corporate and sovereign issues,’ the IMF said.

Malaysia and the Gulf region are the main hubs for Sukuk issuance, though there are a growing number of issuers from the US, Europe and Asia, it said.

While they don’t pay conventional interest like bonds and other commercial papers, Sukuk offer returns, fixed or floating, from the underlying assets. The IMF said like ordinary bonds, Sukuk are also traded in the secondary market.

In the end, despite its unique characteristics, Islamic funds are expected to prosper in Hong Kong, where investors are always looking for new types of instruments that they can add into their portfolio.

Hang Seng’s Lee expects Sukuk to start appearing in the vocabulary of local investors as early as the first half of 2008.

Hopefully, creating a market for Islamic finance in Hong Kong won’t be as hard as building the Great Wall of China, which took decades to complete and caused the death of thousands of workers, thus, earning the nickname, ‘the longest cemetery on earth.’

‘The foundations for building the Islamic fund is already established. It may take time. But experience has shown that Hong Kong is very adept at pushing new products,’ StanChart’s Lau said.