Chapter 3 Islamic Finance and Investment- An Overview Introduction This chapter gives an overview about the concept of Shariah Finance by outlining Shariah principles, features of the investment, key components of Shariah finance and Shariah capital market. Islamic Finance refers to a system that is consistent with Islamic law (Shariah) and guided by Islamic economics. In particular, Islamic law prohibits usury, the collection and payment of interest or Riba. In addition, Islamic law prohibits investing in businesses that are considered unlawful, or haraam (such as businesses that sell alcohol or pork, or businesses that produce media such as gossip columns or pornography, which are contrary to Islamic values). Islamic Finance is not simply an interest free financial system but it also involves other important principles, which encourage entrepreneurship, risk taking, transparency, preservation of property rights and ethical values such as justice, fair dealing and fair pricing, mutual cooperation and respect of the other contracting parties. 3.1. Islamic Finance Principles principles: According to Rahman (2011) 1, Islamic Finance works on the following 3.1.1. Prohibition of Riba (Usury) In Islamic Finance, not only interests are prohibited but also any predetermined payments over and above the actual amount of principal lent. The rationale behind this rule is to consider as unacceptable any growth or interest that is 1 Rahman. U. (2011), Islamic Finance: Key to Economic Prosperity & Social Justice, Islami Tijara, May 201. Pp-7. 52
not driven by effort or risk sharing. As any possible direct, indirect or associated benefits in the hands of the lender are also prohibited, the only loan that is considered as compliant with the principles of the Shariah is the Qard al Hassan ( interest free loan ) 3.1.2. Promoting Partnership and profit Loss Sharing Promoting partnership, and profit loss sharing in contrast with the conventional western approach, in which a lender often insists that a borrower remains liable for the entire principal and interest, not considering the borrower s financial situation, Islamic Finance recommends that a party shares the potential profits if he is also willing to bear the possible associated losses. Therefore, instead of becoming interest-charging lenders, Islamic Finance encourages capital providers to become partners and share profits and risks associated to a business. The principle which thereby emerges is to try and ensure that investment benefits to the entire community by deterring mere lending of money for interest without taking any risk. 3.1.3. Prohibition of gharar (uncertainty) and maysir (gambling) In Islamic Finance, any transaction entered into should be free from excessive uncertainty and speculation. Therefore, contracts must be drafted as clearly as possible to avoid any gharar in the quantity, quality, or existence of the subject matter of a contract. Attached to the prohibition on excessive uncertainty or gharar is the prohibition on transactions involving maysir (gambling). 3.1.4. Prohibition to invest in haram (unlawful) business/products The investment projects which are not in line with the moral values are haram and forbidden. Shariah generally considers as haram and therefore prohibits 53
investment in businesses dealing with activities/products such as: alcoholic beverages, recreational drugs and tobacco products: pork related products: adult entertainment, conventional financial institutions (e.g. banks, insurance companies etc.). 3.1.5. Transaction must be backed by tangible and identifiable assets Transactions must be backed by tangible and identifiable assets. Money is only viewed in the Islamic financial world as a mean of defining the value of something. As such, making money out of money is not acceptable. Therefore, in Islamic Finance, as money itself has no inherent value and is not consided as a true asset, all transactions must be based on tangible and identifiable assets (e.g. commodities, properties, pieces of land etc. 3.1.6. Business Ethics Muslims have a moral obligation to conduct their business activities, as well as their personal life, in accordance with the requirements Islam. Those requirements include moral values and business ethics. Indeed, they should be fair, honest, humble and just towards others. It is a duty for them to earn a living, support their families, and give charity to those less fortunate. In their business activities, it is a moral obligation to fulfill their promises and commitments, pay their liabilities and avoid any monopoly or price-fixing strategies. 3.2. Origin of Islamic Finance Islamic finance has a long history and, in fact, some of the concepts and instruments commonly used today such as mudharabah and musharakah can be traced back to pre-islamic days. After the establishment of Islam in the Middle East, Islamic principles were applied to trade financing practices then and were further formalized 54
and institutionalized. Most of the early formal structures were developed in relation to state-based financing to aid and support business activities. The increasing European influence during the period of colonialism resulted in the adoption of European style financial institutions and products by most of the Islamic countries. However, by the 1960 s, Islamic countries began to re-examine their financial services industry and establish financial systems compatible with Shariah principles. This eventually laid the ground for modern Islamic finance. 3.3. Modern Islamic finance Initial efforts to create a modern Islamic financial system took the route of replicating and adapting institutions and products in the existing conventional system. A major factor in choosing this approach was the fact that the existing legal, accounting and tax frameworks were often modeled after developed, non-islamic financial centers. The creation of modern Islamic financial institutions began with the establishment of Islamic banks. Its rapid growth was, to a large extent, aided by a period of prosperity for the Arab world, which benefited from rising oil prices. The huge amounts of wealth in the region provided a source of substantial liquidity for the nascent Islamic banks. As a result of its early head-start, Islamic banking is today the most developed component in the Islamic financial system and Islamic banks represent the bulk of Islamic financial institutions worldwide. In recent history, the very first financial company based on Shariah principle was Mit Ghamr savings project in Egypt. The latter was in interest free bank concept in which small, short term, interest free loans for productive purpose could be made in favor of the depositors. Additionally, the project aimed to attract funds to invest in 55
Shariah compliant projects on a profit-sharing basis. The Mit Ghamr project was later incorporated in Nasser Social Bank. Picture 3.1: Stages of Evaluation of Islamic Finance The success in developing Islamic banking spurred efforts to extend Islamic practices into other market segments. The next significant development was the establishment of Takaful or Islamic insurance with the principles of compensation and shared responsibility among the community by using instruments that were in line with Shariah. In addition, Takeful also plays an important role in mobilising long term funds, proving risk protection as well as supporting overall economic growth and development. 56
Picture 3.2: Evolution framework of Islamic Finance 57
With the establishment of Islamic banks and takaful institutions, the management of balance sheet liquidity became a major challenge due to the scarcity of Islamic capital market instruments. Islamic banks had surplus funds to invest after proving for liquidity and statutory reserves, and financing for clients. Similarly, takaful operators faced a shortage of Shariah compliant financial products in which to invest, particularly for long term tenure. Some of these institutions funds remained inactive because of limited investment opportunities. 3.4. Growth of Islamic Finance Islamic finance is developing at a remarkable pace. Since its inception three decades ago, the number of Islamic financial institutions worldwide has risen from one in 1975 to over 300 today in more than 75 countries. They are concentrated in the Middle East and Southeast Asia (with Bahrain and Malaysia the biggest hubs), but are also appearing in Europe and the United States. Total assets worldwide are estimated to exceed $250 billion, and are growing at an estimated 15 percent a year 2. The reasons behind the recent growth in Islamic finance are The strong demand from a large number of immigrant and nonimmigrant Muslims for Shariah-compliant financial services and transactions. Growing oil wealth, with demand for suitable investments soaring in the Gulf region. The competitiveness of many of the products, attracting Muslim and non- Muslim investors. Yet despite this rapid growth, Islamic banking remains quite limited in most countries and is tiny compared with the global financial system. 2 Mohammed El Qorchi. (2005). Islamic Finance Gears Up. Finance & Development: A quarterly magazine of the IMF. December 2005, Volume 42, Number 4. 58
Picture 3.3: Growth of Islamic assets The strong growth of Islamic financing continues to be driven by increasing demand; not only by those who invest in such instruments in order to meet their religious obligations, but also by others, including non-muslim, who find some of the risk return features attractive, or investors who subscribe to ethical investment philosophies. Islamic finance is becoming a prominent segment of the global financial market with the most active global financial centers for Islamic financial activities located in London and New York. Many of the global financial players such a Citigroup, HSBC and Standard Chartered, among others, have recognized the potential market demand for these products and have built their capacity and capabilities to originate, distribute and make markets in Islamic financial products. The current size of the assets under management of Islamic Financial institutions is approximated to USD 1 trillion. Although it took approximately forty years to reach this important threshold, many experts predict that the USD 2 trillion 59
threshold will be reached in less than five years and Moodys even estimate that the market s potential is worth at least USD 5 trillion as the industry is continuing to expand globally. In addition, among those USD 1 trillion assets, it is believed that only 25% is invested. One can assume that USD 750 billion is totally liquid and ready to be invested which gives rise to a lot of opportunities for Shariah compliant innovative products such as Islamic Investment funds. 3.5. Islamic financial instruments The Islamic financial instruments are classified into debt instruments, quasi debt instruments and profit and loss sharing instruments. 1. Debt instruments Murabaha Salam Istisna, Qard al-hasan (benevolent loan), 2. Quasi-debt instruments Ijara 3. Profit-and-loss-sharing instruments Musharaka, Mudaraba 60
Islamic financial instruments Islamic Financial Instrument Debt instrument s Quasi debt instrument Proft and loss sharing Murabaha Salam Istisna Ijara Musharaka Mudaraba Picture 3.7: Islamic Financial instruments Murabaha is a purchase and resale contract in which a tangible asset is purchased by a bank at the request of its customer from a supplier, with the resale price determined based on cost plus profit markup; Salam is a purchase contract with deferred delivery of goods (opposite to Murabaha), which is mostly used in agricultural finance; Istisna is a predelivery financing and leasing instrument used to finance longterm projects; Qard al-hasan (benevolent loan) is an interest-free loan contract that is usually collateralized. Ijara is a leasing contract whereby a party leases an asset for a specified rent and term. The owner of the asset (the bank) bears all risks associated with ownership. The asset can be sold at a negotiated market price, effectively resulting in the sale of the Ijara contract. The Ijara contract can be structured as a lease-purchase contract whereby each lease payment includes a portion of the agreed asset price and can be made for a term covering the asset's expected life. 61
Musharaka is an equity participation contract under which a bank and its client contribute jointly to finance a project. Ownership is distributed according to each party's share in the financing. Mudaraba is a trustee-type finance contract under which one party provides the capital for a project and the other party provides the labor. Profit sharing is agreed between the two parties to the Mudaraba contract and the losses are borne by the provider of funds except in the case of misconduct, negligence, or violation of the conditions agreed upon by the bank. 3.6. Regulatory Environment of Islamic Finance The following regulatory are identified worldwide regarding Islamic finance and investment. 3.6.1. Middle East and North Africa Bahrain: Bahrain Monetary Agency provides regulatory framework. IFIs are required to adhere to AAOIFI standards. Kuwait: Fatwa Board of the Ministry of Awkaf and Islamic Affairs acts as regulator. Standards issued by IFSB for Pillar 1, Basel II norms are mandatory. Qatar: Qatar Financial Centre Regulatory Authority is member of IFSB and AAOIFI and as of 2005 has issued rules to govern IFIs. Saudi Arabia: Saudi Arabian Monetary Agency acts as a regulator for all IFIs. The IDB also plays an important role in promoting Islamic banking. UAE: All IFIs must comply with Federal Law No. 6 of 1985. Iran: Since 1979, the entire banking system is strictly Islamic Oman & Egypt: The Central Banks have implemented various restrictive policies preventing the establishment and expansion of IFIs. 62
3.6.2. South East Asia Malaysia: The Shariah Advisory Council (SAC) of Central Bank, established in 1997, acts as the sole regulator for IFIs. Initiatives like tax deductions are adopted by the government to promote IF. All the IFIs have to comply with IF standards issued by IFSB by the end of 2010. Indonesia: Shariah Bureau of the Bank of Indonesia acts as regulator. The Government will need to change the laws (including taxation) on state debt securities or state treasury to promote growth in the sector. 3.6.3. Others India: No separate legislation by Reserve Bank of India. No initiatives undertaken to promote Islamic banking. Pakistan: State Bank of Pakistan acts as a regulator for Islamic banking. Bangladesh: Bangladesh Bank acts as regulator and introduced reforms like lower Statutory Liquid Ratio to promote Islamic banking. US: IFIs must comply with State and Federal regulations, no separate approvals are required. UK: Financial Services Authority (FSA) provides regulatory framework. The government has undertaken various initiatives such as modifying tax legislation to promote IF Germany & France: In very initial stages of development, no major initiatives undertaken as yet 3.7. Components of Islamic Finance Industry 1. Islamic Banking 2. Takaful or Islamic Insurance 3. Real estate 4. Islamic Capital Market 63
Islamic Finance Industry Islamic Banking Takaful or Islamic Insurance Real Estate Islamic Capital Market Picture 3.8: Components of Islamic Finance Industry 3.7.1. Islamic banking Islamic banks today represent the majority of Islamic financial institutions, which are spread worldwide. Currently, there are estimated to be over 265 Islamic banks with a market capitalization in excess of USD 13 billion. Total assets are estimated at over USD 262 billion with financial investments above USD 400 billion. Deposits in Islamic banks are estimated to be over 202 billion worldwide and the average annual growth rate of the Islamic banking industry ranged between 10-20% over the past decade. Islamic banks are characterized by the following features: Transactions that are free from the payment and receipt of a fixed or predetermined rate of interest. Transactions that are based on profit and loss sharing (PLS) arrangements where the rate of return is not fixed prior to the undertaking of the transactions. Business activities and investments that are undertaken on the basis of permissible activities. Transactions that are free from elements of gharar (unreasonable uncertainty). Payment of Zakat (alms or taxes) by the bank. 64
Transactions that operate through Shariah compliant modes of financing. Another salient feature of Islamic banks is the requirement of Shariah supervisory boards. These boards are responsible for reviewing, scrutinizing and endorsing the activities and operations of Islamic banks to ensure that their activities are in line with Shariah principles. 3.7.2. Takaful Takaful is an Arabic word which means Guarantying Each Other or Joint Guarantee. Takaful concept derived from a word Tabarru means Donation, Gift Contribution. The term takaful means a mutual guarantee provided by a group of people in the community against a defined risk befalling one s life, property or any form of valuable things. Unlike conventional insurance, takaful is free from elements of gharar (uncertainty) and maisir (gambling). Takaful is based on definite term, and requires a transaction and clear contract to avoid elements of uncertainty. Currently, two Shariah principles namely mudarabah (profit sharing arrangement) or wakalah (fee based arrangement) are used for takaful contracts. Under mudharabah principles, the takaful operator acts as an entrepreneur and accepts contributions from investors on a periodic basis. The takaful terms and conditions will state how profit from the operations managed by the takaful operators will be shared on a mutually agreed ratio between the participants as the providers of capital and the takaful operator as the entrepreneur. In contrast, under the wakalah principle, the takaful operator is permitted to charge fees at the point the contract is signed in return for its role as the agent for the participants. The operators are also 65
allowed to use part of the fund to cover its management costs. Khan (2011) 3 noticed that Takaful is based on five fundamentals such as Policy holders have to cooperate with each other for their common good, Each policy holder has to pay subscription to Takaful fund for helping members during sudden needs, Losses are divided and liabilities are spread according to the community pooling system, Uncertainty is eliminated in respect of subscription and compensation and Such fund should not be utilized at the cost of others Generally there are three types of takaful products General takaful (Islamic general insurance) This offers protection or coverage against risk or a general nature for companies or individuals. Some of the products are motor insurance, fire and allied perils, worker compensation, marine cargo, property insurance, transportation insurance and others. Family takaful (Islamic life insurance) This provides coverage for individuals or corporate bodies on a long term basis and the maturity period ranges from 10 to 40 years. Some of the products include medical and health plans, education, accident, marriage, as well as hajj and umra plans. 3 Khan. M. Y. (2011). Takaful: An Alternative Framework for Insurance. Islami Tijara. August 2011. Pp-42. 66
Retakaful coverage (Islamic reinsurance) The retakaful companies offer coverage for takaful companies against risks, loss or dilution of its capital and reserves resulting from high claim exposure. There are very few retakaful companies and they are mainly located in the Bahamas, Malaysia, Saudi Arabia and Sudan. 3.7.3. Real Estate The real estate sector is attracting investment from Middle East, as fund raising has got difficult in this sector. India has so far seen investments of over $500 Million for middle-east investors in real estate sector. Investing in real estate is relatively better than stocks or mutual funds where risk and uncertainty are very high. 3.7.4. Islamic Capital Market Capital markets are an important component of the financial system for raising funds for long-term investment. They provide opportunities for diversification of risk through cross-sectional risk sharing. The long-term investments are facilitated through a series of short-term contracts in the form of tradable securities enabling the investors an opportunity to exit or enter through trade. Thus they provide an element of liquidity to the otherwise illiquid assets. The secondary market also provides pricing and valuation of assets on a continued basis thus eliminating arbitrage and inefficiencies. Islamic capital markets are an integral part of Islamic financial system for efficient mobilization of resources and their optimal allocation. These markets complement the investment role of the Islamic banking sector. They are more relevant in an Islamic economy because prohibition of interest entails a greater reliance on 67
equity and asset-based finance. For the investors to know the fair value of their investments, smooth out the risks through diversification and be able to liquidate their positions in real assets, such markets are indispensable. However, the institutional arrangements of the Islamic financial system may be different with respect to these markets as compared to their conventional counterpart. This realization is found to a lesser extent among some stakeholders than the realization of the same in case of Islamic and conventional banking sectors. The Islamic Capital market plays a pivotal role in the growth of Islamic financial instruments. Like any capital market, its primary function is to allow people, companies, and governments with surplus funds to transfer them to people, companies, or governments who need funds. The Islamic capital market functions as a parallel market to the conventional capital market for capital seekers and provides. The Islamic capital market attracts funds from outside as well as inside the market. The international sources might include high-net-worth (HNW) individuals, predominantly Muslim from the oil-rich countries, and others involved in the corporate and business sectors. The Islamic capital market does not prohibit participation by non Muslims, which has increased the growth potential for Islamic products. 4 3.8. Components of Islamic Capital Market Islamic capital market constitutes the following components such as: The Islamic Equity Market Islamic Bond (Sukuk) market Islamic Derivatives Market 4 Bala Shanmugam and Zaha Rina Zahari. (2009). A Primer on Islamic Finance. 2009 The Research Foundation of CFA Institute. Pp-44. 68
Islamic Unit Trusts Islamic Exchange Traded Funds Islamic Commodity Funds Shariah Equity market and Indices Islamic Exchange Traded Funds Islamic Bonds Market (Sukuk) Islamic Capital Market Islamic Mutual Funds And unit trust Islamic Derivatives Market Islamic Commodity Market Picture 3.9: Components of Islamic Capital Market 3.8.1. The Islamic Equity Market and Indices Shariah Compliant stocks are equity Stocks which are successfully following the Shariah Screening Norms or Principles. The key Shariah principles are: Primary business must be halal (permissible according to Islamic law -- Shariah), therefore companies engaged in gambling, alcohol, armaments, tobacco, pornography or pork are excluded, 69
The company which has total Debt to Market Value of Equity (12 Month average) greater than or equal to 33 %, is not consider as a Shariah Compliant stocks. The company which has Accounts Receivables / Market value of Equity (12 Month average) greater than or equal to 49 %, is excluded from the Shariah indices. The company which has (Cash + Interest Bearing Securities) / Market value of Equity (12 Month average) greater than or equal to 33%, is not eligible to involve in Shariah Index. In certain cases, revenues from noncompliant activities are permissible, if they comply with the following threshold: (Non-Permissible Income other than Interest Income) / Revenue less than 5%. On the basis of above principles, during 1999 the first Islamic stock market index named as Dow Jones Islamic Index was launched by Dow Jones Index groups (DJI) in USA. Followed by the DJI, Financial Time Stock Indices (FTSE), Standard & Poor (S&P) and Morgan Stanley Capital Index (MSCI) have started to launch various Islamic indices in the global capital markets. In India, Standard & Poor s and Indian Index Service & Products Ltd (IISL) have jointly launched two major Shariah indices namely S&P CNX Nifty Shariah and S&P CNX 500 Shariah on December 2006. 3.8.2. Islamic Bond Market (Sukuk) The word Sukuk is the plural of the Arabic word Sakk, which means certificate, so Sukuk may be described as certificates of trust for the ownership of an asset, or certificates of usufruct. Sukuk differ from conventional bonds in that they 70
do not pay interest. Islam forbids the payment of interest, but a financial obligation or instrument that is linked to the performance of a real asset is acceptable. 3.8.3. Islamic derivatives market A derivative, a financial instrument whose value is a function of the value of another asset, typically takes the form of a contract in which the investors promises to deliver, or take delivery of, an asset at a specific date and at a specific price. Conventional derivatives include call and put options, futures, forwards, and swaps are used for hedging, arbitrage, and speculation. Islamic finance allows derivatives for the first two purposes hedging and arbitrage- but prohibits their use for speculation or gambling (maisir). As long as riba (interest) and gharar (uncertainty) are avoided, the Islamic derivatives structure used in hedging and arbitrage enjoys significant freedom of design. Islamic derivative products include the structured murabahah deposit, structured options that operate on the principle of wa d (promise), profit rate swaps, and cross-currency swaps, such as the foreign exchange (FX) wa d (a Shariah compliant FX option) and the Islamic FX outright (a Shariah compliant FX forward contract that locks in the price at which an entity can buy or sell a currency at a future date). 3.8.4. Shariah Mutual Funds Shariah mutual funds are funds which are following Islamic finance principles. It is similar to the conventional mutual funds except Shariah mutual funds invest in only Shariah compliant stock and Indices. 71
3.8.5. Islamic Exchange Traded funds Islamic Exchange Traded Fund (Islamic ETF) is a combination of Shariah Compliant stocks. It is like mutual funds and individual share. Like a share, it traded in stock exchanges throughout the trading day. Like a mutual funds, it is issued and maintained by asset management companies. In India, GS Shariah BeES is Shariah Exchange Traded funds which track the performance of the Nifty Shariah index. 3.8.6. Islamic Commodity funds An Islamic commodity funds, like all Islamic financial products, must comply with Shariah principles: therefore, commodity fund transaction are governed by the following rules. The commodity must be owned by the seller at the time of sale because short selling is not permitted under Shariah but forward sales, allowed only in the case of bai salam and bai istisna, are permitted. The commodity traded must be halal, which means that dealing in wine and pork is prohibited. The seller must have physical or constructive possession of the commodity to be sold. The price of the commodity must be fixed and known to the parties involved. Any prices that is uncertain, or that is determined by an uncertain event, render the sale invalid. 72
According to Shanmugam and Zahari (2009) 5, the advantage of a commodity fund is that it is not highly correlated with equity and fixed income asset classes. Hence, it acts as a diversifying asset, particularly when the other assets held are equities and bonds. A commodity fund aims to provide investors with regular income over the life of the fund-income that is linked to the performance of commodities through investments that conform to Shariah principles. The commodity funds generate income from the potential appreciation in commodity prices. 3.9. Summary From this chapter, one can understand that Islamic finance as financial activities which are carried out in the way of Shariah or Islamic rules. This chapter narrated the meaning, origin, growth, types of Islamic Finance and investment. Reviewing the different component of Islamic capital market, this research work is pertaining to Islamic equity market behavior only. With this theoretical background, the following chapters analyses the risk & return, time varying volatility of the Shariah Compliant shares and benchmark indices in the Indian stock market. Finally, the study analyses the awareness and perception of the investors about Shariah investment in India. 5 Bala Shanmugam and Zaha Rina Zahari. (2009). A Primer on Islamic Finance. 2009 The Research Foundation of CFA Institute. Pp-61. 73
CHAPTER 4 RISK AND RETURN BEHAVIOUR OF SHARIAH COMPLIANT SHARES IN INDIA 4.1 Introduction 4.2 Rationale of the Study 4.3 Objectives of the Study 4.4 Hypotheses of the study 4.5 Data variables and its Sources of the Study 4.6 Methodology of the Study 4.7 Empirical Results and Discussion 4.7.1 Descriptive statistics of Return of the Shariah Compliant Stocks during 2nd January 2007 to 30th July 2011 4.7.2 Returns Comparison between Shariah Compliant Stocks and selected Benchmark Indices 4.7.3 Relationship of the Shariah Compliant stocks with respect to Shariah Index during period 2nd January 2007 to 29th July 2011 4.7.4 Relationship between Shariah Compliant Stocks and Nifty Index during period 2nd January 2007 to 29th July 2011 4.7.5 Relationship between Shariah Compliant Stocks and Sensex Index during period 2nd January 2007 to 29th July 2011 4.7.6 Correlation matrix of the Shariah Compliant stocks during the Study period 4.7.7 Descriptive Statistics of the Shariah, Nifty and Sensex indices in India 4.7.8 Correlation Matrix among the Indices 4.7.9 Results of the t-test for returns of the Indices 4.7.10 Risk Adjusted Performance Nifty Shariah and Nifty index during study period 4.7.11 Risk Adjusted Performance Nifty Shariah and BSE Sensex during study period 4.7.12 Results of the ADF and PP test at Level for Unit root test of the Indices 4.7.13 Results of the ADF and PP test at first differences for Unit root test of the Indices 4.7.14 Engle and Granger Residual Based Co Integration test 4.7.15 Pair wise Granger Causality Tests 4.8 Conclusion 74