As the global downturn drags on, battering investor confidence and asset values, Islamic finance markets are expected to increasingly favor the certainty of lease-based bonds over profit-sharing structures to minimize risks. With key sectors such as Dubai property and Malaysian manufacturing in a slump, Islamic banks have grown wary about financing through the once-popular musharaka structure that requires lenders to share a project s risks and rewards. Musharaka-based sukuk involve market exposure and not solely exposure to default risk as with ijara sukuk, said Rodney Wilson, an Islamic finance specialist with the Qatar Foundation. Given the current uncertainty in equity markets I do not believe many potential sukuk investors would want musharaka sukuk in present circumstances. If the market revives and confidence is restored, this may change, but this is unlikely in 2009. Issuers and investors are expected to lean towards ijara or rental-based financing where possible, or look to create new lending structures in the $100 billion sukuk, or Islamic bonds, market. In musharaka, parties contribute capital to a venture with profits to be shared according to an agreed ratio, while losses are generally divided as per the capital contribution ratio. Sukuk ijara, rental bonds that are embraced by Sharia scholars worldwide, were the most popular form of Islamic bond last year, according to rating agency Moody s. Standard & Poor s estimated that more than 45 percent of Islamic bonds issued in 2008 were structured according to the ijara principle. Ijara is a lease where a bank buys an asset and rents it to its client for a fee that includes the purchase price and the profit rate to be earned by the bank during the rental period. Favored for its relatively simple structure and widespread endorsement by Sharia scholars, the popularity of sukuk ijara received a boost after an industry regulator cast doubt on the validity of sukuk mudaraba and musharaka. The Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) ruled last year that repurchase undertakings - a pledge found in most Islamic bonds that the borrower would pay back their face value at maturity - violates the duty to share risk in sukuk mudaraba and musharaka. Issuance of musharaka and mudaraba sukuk fell 83 percent and 68 percent respectively last year, Moody s said. Some bankers and scholars attributed the drop to the AAOIFI ruling, which has prompted the industry to take a fresh look at current structures. Due to the current turmoil and the failure of conventional structures, especially the highly-leveraged ones, more investors are expected to be drawn into learning what the Sharia-compliant structures are about and that could re-define musharaka and mudaraba sukuk as a class of its own, said Helmi Harunarashid, treasury and capital markets general manager at Bahrain s Elaf Bank. But ijara is not without its difficulties when used to structure sukuk. In project financing there should be less commercial issues but when using a sukuk in a similar way to a corporate bond issuance it can become difficult to find suitable assets which are capable of being leased, said Davide Barzilai, a London-based Islamic finance lawyer with Norton Rose. Once you have located the assets, you then have to ensure that the sale to the issuer and the leaseback to the sponsor are permitted by law and do not attract any taxes or duties. The extensive use of ijara has also compromised some of its key features, some scholars have said. For example, to ensure that a long-term lease is economically viable, banks are allowed to peg the rental rate to a well-known variable benchmark that leaves little room for dispute, such as the rate of inflation. But some Islamic banks see this as an implied sanction to tie the rental rate to interest rates, which is banned by the Sharia. Another disputed practice is banks saying in the lease that they will sell the asset to the client when the lease is up. Conservative scholars frown on this on the basis that Islamic jurisprudence does not allow one transaction to be linked to another. Banks are however allowed to give a separate unilateral promise to transfer the asset once the lease expires.
