A DEFAULT by Dubai will put the world of Islamic finance to the test at a time when hard questions are being asked by bankers and lawyers about the protection afforded by financial instruments that are Shariah compliant. The bond that lies at the heart of the threat of default and financial ignominy for Dubai is a sukuk, an instrument invented by bankers and Islamic scholars to comply with a Shariah (Islamic law) prohibition against the payment of interest on money.
A bond that doesn't (in theory) pay interest sounds unattractive but in the Gulf and Malaysia, Islamic finance has flourished over the past decade.
Typically, interest is expressed as a share in a profit, such as the rent paid for use of a property or asset. According to estimates by HSBC Amanah, the Islamic arm of the British bank, outstanding Islamic finance debt is worth $US822 billion ($902 billion).
Even Western investors have been persuaded to dip their toes in the exotic financial tool, tempted by the deep pool of petrodollars available in the Gulf.
Only days before Dubai revealed its bombshell - a threat of possible default on Nakheel's $US4 billion sukuk - GE Capital, the American financial services group, issued the first sukuk by a Western company, raising $US500 million.
The underpinning of a sukuk with assets makes it attractive for use in property lending or asset leasing. The sukuk issued by GE this week was a loan for aircraft leasing.
GE's decision to use the Islamic finance market for funds reflected renewed confidence in a market that had almost collapsed after expansion in 2007 when the Gulf was awash with money fuelled by high oil prices.
Demand shrivelled after the collapse of Lehman Brothers with only $US16 billion issued last year. More importantly, fears surfaced that sukuk failed to provide the same legal protection as conventional bonds. To date, the legal structure of sukuk has never been tested in a court.
There have been high-profile defaults, including the Saudi Arabian Saad Group and Investment Dar, a Kuwaiti Islamic Investment Fund. Investment Dar owns half of Aston Martin, the luxury British car company, and the fund failed to make a payment in April on a $US100 million sukuk issue. In June, Golden Belt, a $US650 million issue by Saad Group, the investment house controlled by Maan al-Sanea, was downgraded to default status.
The concern is that sukuk creditors may not be protected. According to Neale Downes, a Bahrain-resident partner at Trowers & Hamlins, the law firm, it is not clear how creditors will rank in an insolvency.
In some cases, he said that investors have found themselves competing against other creditors, rather than being able to enforce their claim on the underlying asset supporting the sukuk.
But the repeated declarations of support by Dubai's ruler gave the market confidence that the sovereign would stand behind its debts. Only a month before the Nakheel shock, Dubai raised $US2 billion in sukuk issues.
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