Islamization of indices

Islamic finance will serve its purpose better if is propagated as a bouquet of products rather than as a category of banking.
Even as the Reserve Bank of India (RBI) and the finance ministry stand resolutely against the introduction of Islamic banking, market participants are trying to get a slice of the $1 trillion global Islamic finance pie. Last week, the Bombay Stock Exchange launched a shariah-compliant index that will “allow domestic and foreign investors to buy stocks in line with the investment guidelines derived from the shariah”.

The BSE TASIS Shariah 50 index follows the rival National Stock Exchange shariah index, which is linked to the Standard and Poor’s shariah-compliant index. In 1999, Dow Jones became the first to start an Islamic index, as a subset of the Dow Jones Global Index.

Not so long ago, SBI Mutual Fund also introduced the offshore SBI Resurgent India Opportunities Fund. UTI Mutual Fund, too, has put together an offshore shariah-compliant fund, and is now looking to start a domestic shariah fund. Many other fund houses have some variant or the other of an Islamic fund.

Apart from these large institutional players, smaller private sector financial service providers have also been getting into the act. Taurus Asset Management has the shariah-compliant Taurus Ethical Fund. A couple of years ago, EastWind Capital Advisors launched an India Islamic Index comprising some 650-odd shariah-compliant companies.

Several non-banking financial institutions offer interest-free products and shariah-compliant funds in an effort to tap cash-rich Gulf investors and the large investments flowing out from Arab Islamic countries. Indeed, even most banks hold interest-free “Islamic” deposits of some Muslim institutions, only to pay the interest that would have accrued as a donation—thereby making a mockery of the basic tenet of Islamic banking as well as regulation.

Institutional and individual investors around the world are expected to use these indices for portfolio management and benchmarking purposes, and as the basis for structured products and other index-linked investment vehicles. So an “Islamic index”, or a “low-debt non-financial” index is, like all other indices, a benchmark for products such as exchange-traded funds.

Apart from excluding certain industries (such as alcohol, pornography and gambling) and businesses that derive a substantial amount of interest income, the stocks that go into any Islamic index are tested according to three pure financial filters—debt/capital ratio, which should not exceed 33%; the sum of cash and interest-bearing securities, which should not exceed 33% of market capitalization; and accounts receivables, which should not be more than 45% of total assets.

Seen thus, Islamic investing is simply an investment strategy whose growth or demise will depend on the returns that the fund is able to generate. So far, cross-country evidence is that an Islamic index yields significantly higher returns in the bull market period, though it underperforms the FTSE All-World index in the bear market period.

The most interesting difference between an Islamic index and other indices is that the former is invariant to changes in the interest rate. This of course is a natural consequence of the selection of stocks in the index. But what it does do is to absorb rather than amplify interest rate shocks across asset classes.

The learning from the gradual proliferation of Islamic indices and funds, both for proponents of Islamic banking as well as regulatory bodies, is that it is more purposeful and effective to see and sell Islamic finance as a “product” rather than an alternative system to conventional banking.

Not only are there real socio-political issues involved in introducing Islamic banking, there are serious operational and regulatory challenges in running Islamic banking in non-Islamic societies. It has to be recognized that Islamic banking draws upon and leads to many aspects of an Islamic society. The institutional framework of the financial system in an Islamic country is vastly different. For instance, the financing needs of an unbankable individual or enterprise are met through Qarz-e-Hasna (benevolent voluntary lending without interest or any other charge, but not charity) stipulated by Islam. The focus for now should be on research, product development and marketing of financial—and not just investment—products, which are compliant with shariah guidelines.

As a matter of fact, most of the equity and some of the balanced schemes of the mutual funds are or can be made shariah-compliant products without much effort.

Islamic financial products can be effectively used for promoting financial inclusion, especially among the under-banked Muslim community. As the Sachar Committee has documented, the 175 million Muslims who account for 12% of all account holders have a mere 4.5% share in total outstanding loans. The credit per account to Muslims is about half that of other minorities and one-third of “others”, even as the deposit per account for Muslims is almost the same as the national average. With 97% of Muslims engaged in unorganized sector enterprises, this state of financial penetration has an impact on the entire mini and micro enterprise sector.