Discovery Channel Magazine, August 2010

Deep in the deserts of Saudi Arabia sits one of the great archaeological marvels of the Middle East: Mada’in Saleh. Like Petra in Jordan – carved by the same ancient tribe, the Nabateans – the site is made up of hundreds of tombs and facades carved deep into the surface of golden sandstone rock, showing incredible precision and artistry for a people who lived 2,000 years ago.

But there’s one major difference between Mada’in Saleh and Petra, or Palmyra, or Persepolis, or any of the region’s great historic treasures: there’s no-one there. No tourists, no touts, no tour buses. Foreigners rarely come because it’s so hard to get visas; Saudis tend to view the tombs with some superstition. In an entire day at the site, I saw perhaps a dozen people. And that is part of the charm.

To see the article as it ran in Discovery, with photography, follow this link: Medain S’aleh (2)

Mada’in Saleh (“cities of Saleh”), also known as Al-Hijr (“rocky place”), was first occupied by humans as long as 5,000 years ago, and at one stage hosted members of the Arab Lihyanite kingdom. But it’s the Nabateans, an empire that rose and fell from 120BC to AD106, who left their mark here.

Their grand and intricate carvings are as remarkable today as they must have been when they were diligently carved into the rock around the time of the birth of Christ. Unlike Petra, whose community included a treasury, theatre and other buildings, Mada’in Saleh’s main sites are mainly tombs: simple chambers cut deep into the sandstone, with ornate facades in front of them, as much as 50 feet high. They are decorated with patterns, vases, eagles, snakes, sphinxes, griffins and suns – but never people. And best of all, more than 30 of them carry inscriptions in Aramaic allowing us to date them (almost all were built between 1BC and 75AD) and in some cases even telling us who carved them: several, for example, were made by a skilled craftsman called Aftah.

Two millenia on, I am being guided around the ruins by Abdul Aziz, who ten years ago retired from a career in the Saudi air force and police department to become a guide to the area. His family, which he reckons has been in the broader area for 1,000 years or more, moved to the nearby town of Al-Ula in his grandfather’s generation; his uncle was effectively the Saudi government’s representative for Al-Ula under King Abdul Aziz, who unified Saudi Arabia into roughly its current form in the 1930s. “At that time they don’t use the word governor,” today’s Abdul Aziz recalls. “They say ‘one of King Abdul Aziz’s people’.” Even then, as de facto head of the town, there was little involvement for his uncle with Mada’in Saleh, barely 20 kilometres to the north; “They don’t know about this place then,” Abdul Aziz says.

Standing in front of one of the tombs in the traditional Saudi dress of white thobe and ghutra, Abdul Aziz explains how the Nabateans would design and carve their tombs. “They started digging from the top down, not the same as if you are building something from the ground up,” he says. In two places in Mada’in Saleh one sees this clearly illustrated where facades have been started but never finished; they remain there, as if suspended, high in the sandstone. The reason for their abandonment continues to puzzle archaeologists today. “Was there a sudden economic or military catastrophe?” asks Professor John F Healy of the University of Manchester in one of his many books on the Nabateans.

The tombs all bear a similar style. “At the top, all of them have five steps coming down towards each other,” says Abdul Aziz. “That is because if anyone attacks or uses the tomb without permission, they feel in their mind it will come five times.” Some scholars suggest the steps represent five gods the Nabateans worshipped.

Most tombs bear clear marks of the chisels used to carve them – either hard stone or iron. The sandstone, so beautiful and ornate yet fragile, is perfect carving material: Abdul Aziz cheerfully takes a hard stone to an outcrop near a tomb to demonstrate how easily it comes away. For bigger blocks, iron chains were inserted into carved grooves in order to remove slabs, and then the facade was smoothed. There doesn’t seem to have been any revolutionary science involved, just talent, patience and hard work, with some tombs taking years to complete.

Different tomb designs reflected status, with the biggest and grandest apparently devoted to the wealthiest and most important families. The biggest are Qasr Al-Bint (castle of the girl), a rock mass containing 31 individual tombs and the largest single facade, 52.5 feet high; and the extraordinary Qasr Al-Farid, hewn out of a single isolated rock. The jagged Jebel Ethlib mountains and spires, reminiscent of the angular formations of Arizona or Utah, provide a stunning backdrop. Every bit the match of Petra’s Treasury, Qasr Al-Farid has the most ornate facade, with four columns where most have two. “Maybe he was rich,” Abdul Aziz concludes.

From an archeologist’s perspective, it’s the inscriptions that really set the place apart. “Right at the top of the door, they write: this is the owner of the tombs,” Abdul Aziz explains. “It says: you are not allowed to use it, or you must pay.” Scholars who have translated the inscriptions from the Aramaic reveal a remarkably specific range of demands: one forbids violating the bones within the tomb, one altering the inscription, one forging documents about the tomb, and one selling it. The recipients of the fines vary from gods to a king or a governor, and some specify a price, often a thousand Haretite sela’s, or “full price” or “double the price” of the tomb. Some get nasty: “May Dushara [the chief Nabatean deity] curse anybody who buries in this tomb anyone except those inscribed above.” Another: “May he who separates night from day curse whoever removes them forever…”

The fact we can even seen these inscriptions after 2,000 years is an accident of circumstances. “Its desert location has protected it both as a result of its very arid climate and its isolation,” noted the International Council on Monuments and Sites in its report to UNESCO supporting the site’s elevation to World Heritage status, which was approved in 2008. “This has led to the good preservation of the decoration of the facades, and has enabled the conservation of many inscriptions in several ancient languages.” If Mada’in Saleh was as humid or windy as Petra, or as popular, there would probably be much less to see today.

Another reason the tombs have been largely undamaged – and are still little visited – is that local people have appeared nervous about coming. Mada’in Saleh appears in the Qur’an, which says that the tribe there – the Thamud – were guilty of idol-worshipping, forbidden in Islam. Told by the prophet Saleh (whose name the site takes today) to repent, the non-believers instead conspired to kill him and were punished by Allah. Even today, some Muslims – and Saudi is among the strictest Islamic state – may consider it against their religion to visit.

Others just don’t know about it. I met a group of young men wandering around the ruins, who were visiting from Buraydah, about 600 kilometres away. “We have been there for the last 20 years and we hadn’t heard about this place until one week ago,” one says.

For whatever reason, the carvings have withstood the test of time much better than most other attempts at civilisation in the area. In the middle of the site is a restored railway station from the old Hejaz railway the Ottomans built between Damascus and Medina in the early years of the 20^th century. But one only has to walk a few yards away from the station to see the tracks disappear, the steel and sleepers long since ripped up and used for other purposes. The railway barely lasted half a century; the Nabatean carvings, unchanged in millennia, look down imperiously upon its wreckage.

Maybe World Heritage status will bring international and local tourism to Mada’in Saleh; Abdul Aziz thinks it’s happening already. “It was crowded last week,” he says. “In total there may have been 100 people.”

But people have been expecting the site to take off for years. Barbara Toy, the intrepid British traveller, passed through here in the 1960s retracing the old incense trade routes. In 1968 she wrote: “One senses that Madain Saleh is preparing to be discovered.” More than 40 years later, it’s still waiting.

BOX: THE NABATEANS

The Nabateans seem to have been an Arab group, originating from southern Jordan (where Petra, the Nabatean capital, is found) and Palestine. Around 120BC they decided to form their own state, sustained by their location on the vital overland caravan routes from southern Arabia to the rest of the world. They did have their own goods to sell, like bitumen, but their prosperity seems to have come from taxing the caravans. Mada’in Saleh appears to be as far south as they got, and was their southern capital.

Apart from their magnificent carving skills, they are important as a link between the Aramaic and Arabic languages; their inscriptions were Arabic-influenced Aramaic and they may have spoken informally in Arabic.

They showed smart engineering for their time, too. Mada’in Saleh is supported by more than 100 wells, while a clever drainage system next to the Diwan place of worship channelled rainfall into a three metre deep storage chamber.

Their kingdom lasted just over 200 years before being incorporated, apparently without a struggle, into the Roman empire on March 22 AD106. While their descendants must exist across Saudi and Jordan, it is no longer possible to talk of distinct Nabatean descent; the culture has long since been absorbed into Arabia.

BOX: CARVING A HOME

The Nabateans were not the only people to carve their dwellings and temples into rock. One of the most remarkable examples is the town of Lalibela in Ethiopia, where 11 churches have been hewn out of the rock, each one from a single block of granite, with the church roof at the level of the surrounding ground. They were built – or excavated – in the 12^th century by King Lalibela, who gives the town its name.

In the Cappadocia region of Turkey, people carved soft volcanic rocks into houses, churches and monasteries. In some towns, they still live in them. And in the Buzau region of Romania, churches and dwellings have been carved into a mountain, inhabited from as early as the 3^rd century AD to as recently as the 19^th.

Fancy a Mongolian mining company? No? How about a nice Lithuanian bank, or a Kazakhstan gas utility? OK, my final offer: KenGen. What do you mean you don’t know KenGen? It’s Kenya’s most successful electricity company. Durr.

Frontier markets, as stock markets like these are known, require greater savvy and experience than dealing with the most grizzled of used-car salesmen. This is, no doubt, where some of the most extraordinary gains will be made: the emerging star companies of tomorrow in the emerging star countries of tomorrow. But they take the idea of risk and reward to a whole new level – particularly on the risk side of the ledger.

You may not know it, but the countries you are exposed to are dictated more than anything by a group of people sitting in an office on Pine Street, New York. This is MSCI, and it is one of the leading providers worldwide of stock market indices. One of its most well-known ones is the MSCI Emerging Markets, and it is against this index that most emerging market fund managers – including those selling such funds in Australia – are benchmarked.

Consequently, most emerging market funds tend to mirror the geographical allocations of the MSCI index fund quite closely; when a market enters or leaves the index, a lot of capital tends to flow in or out with it as emerging market portfolio managers rebalance their holdings accordingly. The table below shows the 26 nations that make up the index today; even if you don’t hold an emerging markets fund yourself, the chances are your super fund will have at least a modest allocation to it, and it is because of MSCI’s decisions that you probably have an exposure to Brazil but not Argentina, to Hungary but not Croatia, and to Morocco but not Tunisia.

“The definitions to a large extent are given to us as fund managers by the index providers, particularly MSCI,” says Peter Taylor, investment manager for Asian equities at Aberdeen Asset Management in Singapore. (Taylor’s investment decisions affect the emerging market and Asia funds sold by Aberdeen in Australia.) “They have a process and criteria, and under those, some markets are defined as developed, some as emerging, and some as frontier.”

Frontier is actually quite an odd term, because it doesn’t always mean what you might think it means: poorer countries with no established stock markets. In fact, if you look at the table showing the constituents of the frontier markets, it includes some of the richest countries in the world, such as Kuwait, Bahrain and the United Arab Emirates; these have not been promoted to more widely tracked indices mainly because of a lack of easy access to their stock markets, or a lack of maturity or depth within those markets. Also, some frontier markets have stock exchanges almost as old as Australia’s: the Colombo Stock Exchange in Sri Lanka traces its history back to 1896.

“The term ‘frontier markets’ captures a broad universe,” says Taylor. “There are things that you might consider real frontier markets – Central Asia, Mongolia, Papua New Guinea, Pacific islands – where there is an insignificant stock market or sometimes no stock market at all, with the bigger companies listed elsewhere. Then there are what you might think of as the emerging markets of tomorrow: places like Vietnam, Sri Lanka, Bangladesh, Pakistan, and outside Asia places like Nigeria, Kenya or Romania. They may have their difficulties but are sizable countries with a decent number of listed stocks already that could potentially make the leap in the next few years.” And a third category is the wealthy Gulf states. “’Frontier markets’ is not strictly an income level cut-off. If a market has certain types of controls or access problems, it won’t meet MSCI’s criteria to be in the emerging market index. That’s why you have a country like Kuwait defined as a frontier market where it is far richer per capita than, say, India.”

Frontier funds covering all these bases do exist, but they are rare and little marketed in Australia. Franklin Templeton, for example, whose fund manager Mark Mobius has long been a standard-bearer for unloved markets, runs the Templeton Frontier Markets Fund out of Singapore and has so far garnered US$299.13 million under management tracking the MSCI Frontier Markets Index. Its biggest geographical positions are, in this order, Nigera, Qatar, the UAE, Vietnam, Saudi Arabia and Kazakhstan. Its biggest picks, while household names in their own countries, are little known outside them: MTN Group, a South African telco; Kazmunaigas Exploration Production, a Kazakhstan gas company; Saudi Basic Industries, a chemical, fertilizer, plastic and metals producer; Industries Qatar; and United Bank for Africa, which is headquartered in Lagos, Nigeria.

Other funds might pursue a specialist opportunity. In Australia, AMP Capital developed the Vietnam Real Estate Opportunity Fund, for example, investing in direct property there, although funds like this tend to limit access to sophisticated or institutional buyers rather than general retail.

Since few pure frontier funds exist, investors are more likely to get exposure to the frontiers when emerging market fund managers decide to dip their toes in the water of markets outside their benchmark, whether in expectation that those countries will eventually be promoted into true emerging markets and hence become part of their mandate, or simply because they think there are good returns there. In this respect, emerging markets fund managers are most interested in the chunk Taylor labelled the emerging markets of tomorrow, and this is perhaps where the biggest opportunities might lie for bold investors too. “We are quite bullish on prospects for both Vietnam and Sri Lanka long-term,” says Peter Sartori, founder of Treasury Asia Asset Management. “We think it will take longer than many people expect for both markets to become more mainstream or institutional – we expect it is five years away rather than one to three years – but it will likely happen.”

Managers differ on which markets they think offer the real opportunities. “There are a decent number of interesting stocks, particularly in markets like Sri Lanka and Kenya, which have a very long tradition of equity markets,” says Taylor.  “We find more interesting companies in Nigeria and Sri Lanka than we find in Vietnam. Vietnam is everybody’s favourite exotic market, but it’s not a place we find a lot of good companies, whereas places like Nigeria and Sri Lanka have had listed companies forever, with subsidiaries of multinationals listed there, and the local banks.” Aberdeen pursues these opportunities particularly through an Asian small caps fund – this holds stocks in places including Sri Lanka and Pakistan – and to a lesser extent in its broader emerging market funds too.

If you’ve noticed Sri Lanka keeps popping up in this story, that’s a useful point to consider. What’s really changed in Sri Lanka for everyone to be talking about it? It’s not that its companies, which have been around for more than a century in many cases, have become suddenly better – it’s because a crippling civil war has ended. Fund managers with a really long-term view will look at macro considerations like this in deciding whether exposure to a market might eventually make sense. “There has been a tremendous increase of interest in Sri Lanka but it’s got nothing to do with it graduating [to an emerging market definition – which, by MSCI, it still hasn’t],” says Taylor. “People were dismissive of it because of civil war, and suddenly it’s become exciting. We’ve been invested in Sri Lanka forever and that was not a set of investments that have performed very well for many years but suddenly it’s come good: all our stocks have been two or three baggers in the last 18 months.” That is, they’ve doubled or trebled.

Correctly calling the end of a civil war with any accuracy is clearly beyond most of us, but there are other similar factors that are easier to see coming: the world is getting more interested in Mongolia as transformative mining deals (including a vast mine backed by Rio Tinto) get closer to completion, which should lead to greater foreign involvement, faster economic growth and a more developed stock market, for example.

Still, in unpredictable places, these transformative economic moments can go both ways. “People think of emerging markets as a one way bet, but that’s not the case: you do have some emerging markets that go in the wrong direction.” The two key examples at the moment are Pakistan and Argentina, both of which in the recent past have been investment darlings – Pakistan in particular, which for a brief time was a poster child of foreign investment and privatisation before the political and security situation worsened. Both those markets now languish in the frontier indices rather than the emerging market ones, with a consequent loss of interest from international capital. Similarly Kazakhstan was for several years considered a barometer for the emergence of Central Asia, and attracted a lot of attention as it liberalised its banking sector – which pretty much went broke in the financial crisis, taking a lot of foreign money with it.

No Australia-based investor in their right mind would seek to buy a stock listed in Ulaanbaatar or Lagos without a great deal of prior knowledge, but there are other ways of getting exposure to odd parts of the world through a single stock. To stick with the Mongolia example, more and more of the world’s most powerful investors – such as Temasek, Singapore’s sovereign wealth fund, and China Investment Corporation, its equivalent in Beijing – are trying to get a foothold in companies and mining interests there in expectation of growth. One of the companies that sovereign funds have bought into, South Gobi Resources, has since been listed in Hong Kong, which can be easily reached by Australian investors and is a well-governed exchange. (It’s worth noting, though, that the stock has crashed 30% since listing, although the rest of the market is well down too.) You don’t even have to go that far to get exposure to some frontier markets: here in Australia, Lihir Gold gets most of its revenue from a gold mine in Papua New Guinea, and much of the remainder from Cote d’Ivoire. A great many mining companies, BHP Billiton and Rio Tinto included, have some exposure to the frontier mining idea.

It’s also very easy for Australian investors to invest in the USA, and doing so gives you access to the greatest range of exchange-traded funds (ETFs). These behave like buying a single share, but they reflect the performance of an entire index. Providers in the US such as Vectors, PowerShares and Claymores offer frontier ETFs, or ETFs tracking particular areas such as the MENA area, which means Middle East and North Africa. Examples are the Claymore Frontier Markets ETF (whose New York Stock Exchange symbol is FRN), PowerShares MENA Frontier Countries ETF (on Nasdaq, code PMNA) or Market Vectors Africa ETF (NYSE, NFK). Be aware that an ETF gets you exposure to the dross as well as any diamonds that might be found, and also that buying an ETF in America from Australia also exposes you to currency movements. iShares, the biggest provider of international ETFs sold in Australia, covers several individual Asian emerging markets in its Australia-listed products (Taiwan and Korea, for example), but for more far-flung stuff you have to go to their New York-listed products too: they have ETFs for Peru, Chile and South Africa, for example.

Otherwise, real frontier investing tends to be the preserve of private equity players who bring chunks of daring institutional money together to put into very new markets with a long-term timeframe. Examples are Altima Partners, the former Deutsche bank equity special situations group which peeled off from the bank in 2004 and has since launched funds including the Central Asia Fund, covering Armenia, Azerbaijan, Georgia, the Kyrgyz Republic, Tajikistan, Turkmenistan and Kazakhstan; the Dubai-based private equity specialists Abraaj Capital, which runs the Abraaj/BMA Pakistan Buyout Fund alongside a local Pakistan bank; and a group called Acap Partners, run by a former McKinsey staffer called Pierre van Hoeylandt, who runs a truly frontier-spirited entity, the Afghanistan Reconstruction Fund. It takes big money and immeasurable patience and risk appetite to participate in these sorts of ventures.

Generally, though, the idea of wanting to get in early to markets that will grow in importance, liquidity and influence is sound enough, and allied to the broader trend of Asian or emerging market growth. “Asia ex-Japan has only been on the radar for most Australian institutions for the last five years,” says Sartori. “It will definitely remain on the radar and will continue to grow in importance as the region continues to grow relatively stronger than elsewhere in the world and Asia gets larger in global indices. The frontier markets will contribute to this, but are a few years away from being more meaningful.”

BOX: The Middle East

The Middle East, which for investors is chiefly the big oil-rich markets of the Gulf Cooperation Council (GCC), is an odd case. Massively wealthy, their stock markets do not appear in global indices because by and large their markets either lack suitable access for foreign money, or because they are too small or immature. Saudi Arabia’s market doesn’t even make it into the frontier index because foreigners cannot buy Saudi shares (although they can create the effect of doing so synthetically with new investment structures).

There are funds that do invest exclusively in these markets: one of the biggest is the Schroder Middle East Fund, sold within its International Selection range, whose biggest positions are in Turkey, Saudi Arabia, Kuwait, the UAE and Qatar. “The long-term case for investing in the region remains strong,” says Rami Sidani, fund manager at Schroders in Dubai. “Middle Eastern countries are at a relatively early stage in their development and have strong growth potential. While many of these countries continue to benefit from oil and gas riches, they are investing in new products and skills to diversify away from reliance on energy exports. The region has a young, fast-growing population which should also contribute to a more rapid economic development.”

But emerging markets managers often consider the Gulf’s position in frontier indices an anomaly given that, as highly wealthy states, their future growth profile is likely to be quite different to a Vietnam or Sri Lanka.

In any event, MSCI has been talking for some years about adding some Gulf markets to the emerging markets index; Kuwait, the UAE and Bahrain are the ones that are most frequently mentioned, even though Saudi Arabia has much the biggest market in the region by market capitalization. It will be an interesting day when it happens, because calling Kuwait an emerging market – with its high performance luxury cars, bounteous oil revenue and soaring per capita income – seems just as odd as calling it a frontier.

The Abu Dhabi Investment Authority – perhaps the world’s largest institutional investor – has had two momentous things happen to it this year.

Most obviously, in March, it mourned the death of Sheikh Ahmed bin Zayed Al Nehayan in a glider accident in Morocco. Sheikh Ahmed was a royal family member, brother of the president of the United Arab Emirates – and managing director of ADIA. The Spectator was in Abu Dhabi when his death was confirmed and the country entered a three-day period of mourning. Meetings were cancelled, hymns and tributes replaced programmed television, and outside ADIA’s gleaming headquarters on the Corniche, coaches lined up to take staff members to the palace to pay their respects.

But after a respectful period, ADIA named Ahmed’s younger brother, Hamed, as the new MD. From the perspective of the outside world, nothing will change: the same family will be in charge and not one person The Spectator spoke to – all of whom have day-to-day interaction with the institution – expect any change in policy or approach from the shift at the top. “I don’t want to be flippant,” says one western money manager, “because I have had no problem at all dealing with these people and was genuinely sad about the accident. But Ahmed to Hamed – it’s even an anagram. That’s something of a metaphor for the continuity you should expect to see.”

See this article as it ran here: Wright_Abu Dhabi (2)

Instead, to observers, one of Sheikh Ahmed’s last acts in office may prove to herald a more significant shift, in pragmatic terms, than any change in senior management. This was the ADIA Review 2009, a 33-page document published less than two weeks before his death.

An annual review might not sound much, but that’s to misunderstand the extraordinary secrecy that has previously surrounded this vastly powerful institution. Until recently, a visit to the ADIA website was an exercise in frustration. There was a picture of a building, a phone number, and a fax number. One would scan the page looking for the links to click through to find out more about investments, assets, philosophy – anything. But there weren’t any links. That was it: that picture of the building was all ADIA was prepared to disclose to the world about its operations.

And what operations they are. The precise figure for assets under management has always been a closely-guarded secret, and one not revealed by the new report, but the sheer range of estimates – from US$300 billion to, pre-financial crisis, as much as US$1 trillion – gives an impression both of the scale of wealth and the crushing lack of reliable knowledge outside ADIA itself about just what that scale is. (Informed voices put the true range at between US$400 and US$500 billion – but that’s hardly pinning it down. The gap between the two figures is bigger than, say, Vietnam’s entire economy.)

There are things we have always known, usually triggered by ADIA breaching some disclosure threshold somewhere in the world and being required by a local regulator to state its holdings: we know it is the second-biggest shareholder in Citigroup (and is suing it for misrepresentation, but that’s another story); that it bought a stake in Gatwick Airport this year; that it used to hold a stake in Manchester United, but ditched it, uncomfortable with the attention it brought. But we only really know what a third party regulator has required it to tell us.

One of the main reasons the true asset figure has never leaked is that hardly any of the 1,200-strong workforce at ADIA know what it is. Even to an extremely senior level of internal portfolio manager, the number is a secret. Those who have worked there describe ADIA as an incredibly siloed organisation: you know what your mandate is but you have no idea how it fits into the broader, overall strategy. Some say they didn’t even know what the person at the neighbouring desk was responsible for.

Against such a backdrop, a 33-page review is an absolute milestone. So what did it tell us, and what does it mean for the west?

A few highlights: ADIA is truly global in its investments, from Australia and New Zealand to most Asian and southeast Asian nations, most of the Americas, all of Europe bar the Balkans, and a few pockets of Africa like Morocco, Egypt and South Africa. Another: ADIA’s staff is more international than many had expected, with only 31% of the staff Emiratis. The biggest chunk – 36% – are Asian and 40 nationalities are represented. This fits in with reports from many who have worked there that a silo within the business will be run by a local, with foreigners immediately beneath them.

The British and international industry most likely to be affected by the report is funds management – particularly since most multinationals service the Middle East sovereign wealth funds out of London. This report tells us that some 80% of ADIA’s assets – whatever their true total – are up for grabs for external fund managers, with only one fifth, smaller than most expected, handled in-house by ADIA’s sophisticated internal portfolio management teams. But there’s a catch: we also learn that 60% of ADIA’s money replicates indices – that is, it goes to passive strategies. The single biggest thing we learned from this document is that groups like Barclays Global Investors and State Street, masters of the passive approach, are making some very good business in the Middle East.

The next thing we learned is that for all its famed sophistication, nouse and innovation – it is a first mover in all sorts of asset classes, active in alternatives since 1986 and private equity since 1989 – ADIA has not, it seems, been all that good. ADIA has taken a tentative approach to disclosing performance, opting only for exceptionally long-term 20- and 30-year numbers, but over the 20 years to December 31 2009 it returned 6.5% a year.

“That’s not particularly impressive,” says one fund manager. “You’d expect that from a well-diversified bond fund.”

But why is ADIA telling us even this? It doesn’t have to tell us a thing: never has done. For years, Middle East sovereign funds like ADIA, the Kuwait Investment Authority and Qatar Investment Authority have reacted with detached bemusement at calls from Western governments for greater transparency among sovereign funds. Why, they ask? What’s it got to do with them? The KIA, for example, has been managing money for more than half a century without ever feeling much of a need to tell the world at large what it’s doing with it.

Ahmed’s letter in the report – which will now stand as his parting remarks to the world – starts to explain what’s changed. He spoke about “the value we attach to our most important asset – our reputation”, and this provides a first clue. As the world became increasingly aware of the scale of sovereign wealth, scrutiny increased, peaking in 2007 before the global financial crisis put other matters on the world agenda. There was a sense, largely misplaced, that these institutions were threatening and destabilising, particularly as they came to own increasingly large positions in American banks.

Those who have dealt with sovereign wealth funds say that most of them, and certainly ADIA and the KIA, invest responsibly and that the fears are misguided. “There is a directly inverse relationship,” says one fund manager, “between somebody’s willingness to shout about all this and their having anything sensible or informed to say.” But it appears eventually to have bothered Abu Dhabi’s royal family that its reputation was suffering through lack of openness – and hence this first step.

So in 2008, ADIA agreed with the US Department of the Treasury and Singapore’s sovereign wealth fund, GIC, a set of policy principles and standards for sovereign funds. Later that year it took on the co-chair role of a working group of 26 sovereign funds which produced the so-called Santiago Principles on sovereign investment. Dubai’s absurd handling of some of its own investment ambitions may also have triggered a desire to differentiate itself as smart and conservative.

So what do we learn for the west from all this? Well, ADIA is not one of the funds that tends to storm in to western markets with brazen bids for stock exchanges, waxworks or supermarket chains – that’s Qatar’s young upstart, the QIA. But ADIA’s disclosure is likely to prompt other previously secretive institutions to do the same thing and tell the world more about how and why they invest. ADIA is also a role model for fledgling sovereign funds – the Libyan Investment Authority, for example, reportedly aspires to look like it one day – and if they follow the ADIA model of putting four fifths of their money into foreign hands, that will constitute great news for London’s money management industry. But really there was only one message ADIA really wanted to get across to the West: don’t be scared.

In December, world markets reacted strongly to the news that an expected default on a US$3.52 billion sukuk issue from Dubai’s Nakheel Developments would not now take place, following a US$10 billion bailout by the Abu Dhabi government. For creditors in the Nakheel sukuk – the Islamic equivalent of a bond – the news was clearly good: only weeks earlier they had been told that Dubai World, the state-owned holding company that includes Nakheel, was entering a debt standstill and that they would have to wait indefinitely to get any of their money back. But one can also argue that Nakheel’s step back from the brink is a lost opportunity.

How so? Well, the Nakheel/Dubai World standstill represented something that has to happen at some stage, but hasn’t yet: a default in an international sukuk. Without it, uncertainty hangs over the whole sector and impedes its maturity. That, in turn, hinders its development as an asset class for fund managers.

The sukuk industry is youthful and most of its activity has taken place in the last decade. Zawya, a research group in the United Arab Emirates, calculates US$106.6 billion was raised through 747 sukuk issues between December 1996 and September 30 2009, the majority of it since 2002, and that more than 90% of that total is still outstanding, with only US$12.6 billion having matured so far. At a local level, defaults have happened and been worked out in Malaysia’s sophisticated ringgit sukuk industry, but in the more complicated global, cross-border deals, they remain an unknown quantity. Two have happened in the last 18 months – Kuwait’s Investment Dar, and the US-based oil firm East Cameron Partners, which is under Chapter 11 bankruptcy protection in the US and has a sukuk outstanding that will be impacted by that filing. But neither has yet made it to court so not much can be learned from either.

A Nakheel default – on the biggest sukuk ever launched – might have answered a lot of questions about how the sukuk market works when, as must inevitably happen from time to time, things go wrong. That would have helped to create a path for the future which, in turn, would give investors a clearer idea about the level of risk they are entering into when they buy a sukuk.

A sukuk behaves broadly like a conventional bond, in that it pays out a predictable and regular amount over a pre-agreed period of time. Its key difference from conventional finance stems from the fact that in Islam, riba, or interest, is prohibited. So sukuk use the cashflows of an underlying asset, usually a property, to pay out a regular income stream. While this may sound like just semantics, the point is that money isn’t just turning into more money without doing something else – which is what happens with interest on a bond – but is instead a sharing of the profits being created by a tangible asset. In Nakheel’s case, this was a 50-year leasehold on two plots of land in the Dubai waterfront.

So the first question many people have is: if things go wrong, what are the rights of the creditor to the underlying asset? Some investors believe that, had Nakheel defaulted, they ought to have had rights to those underlying plots of land (or at least the leasehold on them). Others believe that, unless it’s specifically stated in the documentation, the creditor’s rights are instead to the obligor’s balance sheet – and that the underlying asset is only there to make the whole thing Shariah-compliant, not to serve as collateral. This latter is the norm in Malaysia, where these issues have been successfully tested by the courts. We don’t now know what the answer would have been for Nakheel.

Things are much more complicated in an international than a domestic deal. A Moody’s analyst, studying the sukuk, says that in the case of Nakheel, different parts of the structure fall under different legal codes. The declaration of trust, the transaction administration deed, agency agreement, certificates, co-obligor guarantee and the Dubai World guarantee are governed by English law. The purchase agreement, lease, mortgages and share pledge, amongst other things, are under UAE laws – which are Islamic. That would have a big bearing on the enforcement of rights in a default. And, even those areas that are governed by familiar and commercially-savvy English law are not clear cut, because any English judgment would need to be enforced locally.

And for that, consider the position of the creditor, going after Nakheel assets – owned, ultimately, by Sheikh Mohammed bin Rashid Al Maktoum, Dubai’s emir. Who’s going to go into a court (in which there is a symbol of the ruler behind the judge) and say: “Give me that land. It’s mine”?

In practice, for this reason and the general reluctance of creditors to head to the courts in the Gulf, Nakheel would almost certainly never have made it to court but instead been hammered out in a behind-the-scenes restructuring – but this, too, would have been instructive. A Nakheel default would have told potential buyers in any global sukuk just what they should expect – what they really own, where they would rank in bankruptcy restructurings, what their recourse is to assets in different jurisdictions and under different laws.

One good thing that does appear to have come out of the confusion is the promise of a new bankruptcy law. One of the things creditors, and market-watchers generally, had been so concerned about as Nakheel approached default was the lack of clarity about bankruptcy and the whole process of pursuing a debt. This, too, is an area of difference with Malaysia, where the bankruptcy legislation is clear and tested. When Dubai announced the Abu Dhabi bailout in December (in a statement from the chairman of Dubai’s Supreme Fiscal Committee), it announced a new bankruptcy law in the same release, saying: “The law will be available should Dubai World and its subsidiaries be unable to achieve an acceptable restructuring of its remaining obligations.”

That, at least, does represent some of the dispute resolution maturity that the industry needs to grow further. And this matters considerably to portfolio managers in the region. So far, sukuk-only funds are reasonably rare: examples are from Dubai’s Algebra Capital, in which Franklin Templeton owns a stake, and some newer Saudi Arabian asset managers such as Jadwa Investment Co. But, although it’s difficult to track, sukuk are much more widely held than that, and not just in the Middle East. In recent years the yield pick-up offered by sukuk over some conventional bonds, coupled with the supposed security of being underpinned by real assets, have seen sukuk move into portfolios run by conventional asset managers worldwide too. Prominent holders of the Nakheel sukuk are understood to include BlackRock, Ashmore and the New York hedge fund QVT Financial.

The sukuk market faces other challenges too. One is that, again notwithstanding Malaysia’s domestic market, they just don’t trade: there is hopelessly thin secondary market liquidity because supply is still exceeded by demand and people who buy them don’t want to sell. Also, there are a number of different structures used for sukuk, and the most commonplace was recently denounced by one of the world’s leading Shariah scholars, Pakistan’s Sheikh Taqi Usmani, in a speech that appeared to suggest that 85% of non-ijarah sukuks were not Shariah compliant at all (ijarah is a type of structure that is increasingly commonly used for sukuk in the Middle East, but less so in Asia). This raises another issue: standards on Shariah compliance vary between the Middle East and southeast Asia, and even within Gulf jurisdictions, which impedes cross-border sales and trading of sukuk.

Nevertheless, the fact that this youthful market faces challenges does not suggest it lacks a vibrant future; these are necessary teething troubles from which the sector has the potential to emerge stronger. More sukuk mutual funds are bound to follow in due course, while the presence of individual sukuk in global conventional debt portfolios is here to stay. It’s just that, for true acceptance globally, there has to be clarity on what happens when things go wrong – because sooner or later, they always do.

Two years ago international fund managers were excited at the possibilities arising in the Middle East. Soaring oil prices were driving exceptional economic growth; stock markets had proven themselves uncorrelated to those in the rest of the world; the region’s vast sovereign wealth funds – including by far the biggest in the world, the Abu Dhabi Investment Authority – were showing an increasing willingness to give their portfolios out to external managers to run; and the biggest market of them all, Saudi Arabia, was starting to open up to the world.

In the time since, much has gone wrong. The Middle East’s stock markets did stay uncorrelated for the opening months of the financial crisis – but then fell just as far as everywhere else, only faster. “What world markets had experienced in six months, we experienced in six weeks,” says one local fund manager ruefully. The oil price plunged from US$140 a barrel to US$37 before recovering (to US$82 at the time of writing), and not all economies have followed the rest of the world in emerging from the global crisis. Dubai, in particular, is still in the thick of debt restructuring problems, while Saudi, the main prize in the region, has been mired in high-profile defaults.

The fundamental problem for foreign fund managers, in a nutshell, is this: the foreign money that was coming into the Middle East has to a large extent left, and, worse, it hasn’t come back. International capital fled all emerging markets as the global financial crisis kicked in, but many of them – especially in Asia – have enjoyed a surge of returning capital as institutions have regained risk appetite. But the money doesn’t seem to have returned to the Middle East.

At the heart of this problem is the fact that the Gulf Cooperation Council (GCC) nations don’t appear in the major international indices that global capital usually track. A year ago the expectation was that Kuwait and the United Arab Emirates would be added to the MSCI Emerging Markets index, which would have prompted a huge increase in the volume of funds that would have sought allocation in the region in order to match their benchmarks. But that no longer appears to be on the cards, at least in the short term. The region’s biggest market, Saudi Arabia, won’t be added to an index until it becomes easier for foreigners to own shares in the country: at the moment, a proxy security called a P-note is used to create synthetic exposure to Saudi stocks, rather than foreigners being able to own the securities themselves. (Even that’s an improvement: until recently foreigners could only get Saudi exposure by buying a Saudi Arabian mutual fund.)

And if international capital isn’t going there, the local money isn’t proving as easy to get as many had hoped. Few foreigners want to go after retail money, which can only really be reached by the widespread local bank distribution networks. The sovereign funds of Abu Dhabi, Kuwait, Qatar and (through its central bank) Saudi Arabia are still among the most powerful institutional investors in the world, but were burned badly in the crisis, with several having bought into US banks far too early; nursing their wounds, they have started to focus more on investing in their own region than the west, which doesn’t help international asset managers pitching for their business. Additionally, they have raised the bar on the strength they require in their counterparties, which has the effect that investment managers either need a very strong parent or a long-standing and happy existing relationship with the fund in question. The barriers to entry, high already, have got higher. For many fund managers, the real target is the large family offices that exist in places like Saudi Arabia, Kuwait and the UAE, though the suspicion remains that the real money there goes straight through the private banks of Geneva, Zurich and London rather than being captured and serviced on the ground in Riyadh, Abu Dhabi or Kuwait City.

That said, there is still a decent investment case for the Middle East, and until Dubai’s near-default on its Nakheel sukuk in December (see separate article), there was a growing sense that the region offered some of the most tempting valuations in world emerging markets. The fundamentals, although interrupted, are still impressive: Middle East GDP doubled between 2002 and 2007, according to Morgan Stanley; national income in the GCC nations averaged 19% growth in the four years to 2007, with per capita GDP averaging 15% growth through that period; and population demographics are in a sweet spot with a total labour force of 185 million expected by 2020 and a declining age dependency ratio, according to the International Labour Organization. Despite oil’s fluctuations, those pre-crisis trends should continue as the region emerges from crisis – and although the falls in oil prices didn’t help Gulf economies, the truth is most of them break even (in terms of balancing the budget) at between US$25 to US$45 per barrel, meaning there is still plenty of revenue to support infrastructure development.

So how should fund managers play the region? The trend pre-crisis was for more and more fund managers to set up in the region – typically an office in Bahrain or the Dubai International Financial Centre – and staff it at first with a sales presence. These groups would typically then target institutions rather than retail, or would supply local banks with product (sometimes white labelled, sometimes co-branded) to distribute through those local branch networks. Only a handful ever put manufacturing on the ground here: examples are Schroders, which runs a Middle East fund that is sold both internationally and regionally; Credit Suisse; ING; and Deutsche, which has pulled back from asset management globally and has reduced its manufacturing presence in Dubai. Another approach was taken by Franklin Templeton, which bought a 25% stake in the Dubai-based boutique, Algebra Capital, and uses that for its product manufacturing needs. Several other groups offer Middle East expertise to those who need it – private clients, for example – or use London-based teams for whatever Middle East stock exposure they need in global or regional portfolios. For the moment, there’s little reason to advocate international managers pushing further into the region than they already have.

The argument as to which centre foreign fund managers should use has died down as economic activity has faded. Bahrain remains the place with by far the most registered foreign funds; Dubai has probably attracted the most foreign names, albeit often with a skeleton presence; and Qatar, despite successes in other areas of its financial centre, has only really attracted one big name on the asset management side – Axa.

Saudi Arabia is a separate case. Saudi is the market that matters most in the Middle East: the largest economy, the largest domestic mutual fund industry, the most oil, the richest people. Foreigners have historically been limited in their involvement in this country, but several have stakes in local partnerships: HSBC (in SABB), Goldman Sachs (in NCB Capital, the investment banking arm of National Commercial Bank), RBS (in Saudi Hollandi, through the old ABN Amro business), Credit Agricole (in CAAM Saudi Fransi, a JV with Banque Saudi Fransi), and BNP Paribas (in The Saudi Investment Bank). Each of these therefore have a stake in highly active local funds management businesses, with the HSBC/SABB and Goldman/NCB Capital (through its Al Ahli range) among the most powerful in the country, although they don’t have overall control either of the revenues or the direction of the businesses.

On top of that, the arrival of a new regulator, the Capital Market Authority (CMA), in 2003 led to major changes in the financial services industry in Saudi Arabia, and has included the issuance of dozens of new licences in recent years. Many of these have involved foreign partners, among them Credit Suisse, Morgan Stanley, JP Morgan and Merrill Lynch (now part of Bank of America). In practice, many of these licences are being used more for brokerage than for asset management, but they do have the right licences to grow businesses in this area and one of the key developments of the next few years will be the methods they use to do so.

In sum, the Middle East still has the same potential it always did, but global fund managers will see little reason to build a substantial presence on the ground without evidence of two things: foreign money wanting to be deployed in Middle East markets, and Gulf sovereign wealth funds wanting their investment managers to be based in the region.

Asiamoney, December 2009

Dubai went to the brink – and it’s still there. Abu Dhabi’s decision in December to supply Dubai with $10 billion for debt repayment allowed it to forestall, at the very last moment, a default on the world’s largest ever sukuk – the $3.52 billion Nakheel Developments issue which matured on December 14. But it doesn’t repair Dubai’s tarnished reputation as a financial centre and issuer, or give any reason to suggest investors will rush back to help Dubai refinance the $100.6 billion of outstanding debt Moody’s believes Dubai Inc owes, $12.5 billion of it due next year. And it leaves significant questions unanswered about the credibility of the sukuk industry that has become a bedrock of global Islamic finance.

It is in some sense a shame that Nakheel didn’t enter formal default. While that sounds absurd, professionals across the Middle East and the Islamic finance industry globally had become increasingly sanguine about a potential Nakheel default, believing it would have answered vital questions about just what happens when a sukuk turns bad.

These, after all, have never been answered or tested satisfactorily. The sukuk market has grown with mercurial haste in the last 13 years: The UAE-based research group Zawya says there were $106.6 billion of sukuk raised in 747 issues between December 1996 and September 30 2009, most of it since 2002. But such is the sector’s youth, well over 90% of that total is still outstanding: to date only $12.6 billion has matured. Consequently, outside of Malaysia’s more mature domestic sukuk industry, there has been hardly any experience of default. Two did fall in the global financial crisis – Kuwait’s Investment Dar, and the US-based oil firm East Cameron Partners, which has a sukuk outstanding but has filed for Chapter 11 bankruptcy protection – but since they have yet to make it to court (and may never do so), it is hard to learn much from them yet.

There is a feeling, therefore, that this had to happen sooner or later, to answer that nagging question: what if? What happens when something goes wrong? For this reason, after the initial shock when Dubai announced a debt standstill and a $26 billion restructuring including the Dubai World state-owned holding company and its Nakheel Development subsidiary, market practitioners had started to look forward to a little clarity.

“In a sense, defaults in a type of transaction reveal the actual rights held by investors in that type of transaction,” says Ayman Adel Khaleq, partner at Vinson & Elkins in Dubai. “Pure economics aside, the defaults facing various sukuk in the current market are therefore not entirely negative occurrences.”

The same sentiment was echoed all over the world in the weeks up to Abu Dhabi’s intervention. “The sukuk market is growing up,” said Dino Kronfol, managing director at Algebra Capital in Dubai, one of the few Gulf asset managers to run a mutual fund investing exclusively in sukuk. “Nakheel will be an opportunity to set some important precedents. First and foremost, we are going to have a better understanding of what the path is going to be like post-default.” Three thousand miles east in Malaysia, Badlisyah Abdul Ghani, CEO of CIMB Islamic Bank, said: “There’s always a silver lining. What is happening now will make the market even stronger in future because it will cause people to build the necessary framework and infrastructure to make sure these things do not happen again.” Well, maybe now they won’t.

So what’s at issue here? Part of the uncertainty is structural. The principle of a sukuk is that it replicates the mechanics of a conventional bond in a Shariah-compliant way. In Islam, riba, or interest, is prohibited: money can’t just turn into more money without doing something else. So instead, sukuk use the cashflows of an underlying asset – typically a property – which pay out an income stream. In Nakheel’s case (there are actually three separate sukuk worth $5.25 billion maturing between December 2009 and January 2011), that’s a 50-year leasehold interest in two plots of land within Dubai Waterfront. In a sukuk, the return is a share of profits among the creditors.

But if it goes wrong, it’s not clear what the rights are of creditors to the underlying assets. Unless it’s specifically stated in the documentation, a creditor’s right is not typically to that cash-generating asset – which is there chiefly to ensure Shariah compliance – but to the obligor’s balance sheet, which can be a very different proposition. Also, the ethical stance of a sukuk is an equal sharing of profit and risk. Well, if it all goes sour, doesn’t this principle of equal sharing alleviate any obligation the issuer has to continue to pay out if it feels it can no longer do so?

Nobody is entirely sure. “Until recently the growth of the sukuk market has been driven more by an abundance of financial resources than by, for example, regulatory or legal considerations,” says Khaleq. “In conventional finance and investment markets, the post-default path is well worn.” Consequently when you structure and document a new conventional bond, you take into account a worst case scenario like a default or insolvency, based on what you’ve seen happen before. “Precedents indicating what such a scenario may entail are readily accessible. The same cannot yet be said for Islamic transactions, particularly in debt capital markets.”

Abdul Ghani says in Malaysia, through experience, these things are understood and therefore practised. “The majority of sukuk are unsecured paper, and there is no expectation whatsoever on the part of the creditors for using the underlying asset to get back their money,” he says. “That asset is just there in a transaction to make it Shariah compliant, it is never intended to be collateral.” Instead, creditors can seek a liquidation of a sukuk, in a process well established over the years in Malaysia’s courts. And this, really, is the difference: experience. “One of the major things that is missing in the Gulf is the bankruptcy law,” he says. “That’s not fully tested.”

One other area Nakheel could have shed some light is the issue of multiple jurisdictions. There are major challenges with different bits of a sukuk being covered by different laws and codes. Khalid Howladar, an analyst specialising in sukuk for Moody’s, says that the declaration of trust, the transaction administration deed, agency agreement, certificates, co-obligor guarantee and the Dubai World guarantee are governed by English law. The purchase agreement, lease, mortgages and the share pledge, among other things, are under UAE laws – which are Islamic. “This complicates issues such as enforcement of rights,” he says. “Ultimately, even an English judgment will need to be enforced locally, and given the conflict of government ownership of the entities involved, as well as the immaturity of the legal environment, it’s not clear how transparent or fair local courts would be.”

In truth, nobody in their right mind would have taken Nakheel’s backers – ultimately, Sheikh Mohammed bin Rashid Al Maktoum, emir of Dubai – to court in the United Arab Emirates. “It’s a brave person who stands up in court and says to him: ‘that’s mine, not yours’,” says one banker. “When you go to court in Dubai, there’s a symbol of the ruler behind the judge. Are you going to go into that court and ask for the ruler’s assets?”

Kronfol also doubts the point of going to court. “It’s never helpful. And even if you got the court to give you access to the asset, why would you? It will be complicated – you won’t own the land, you’ll own a lease, and that land is just desert with a fence around it. You’re much better off with a planned restructuring.”

The sukuk market has a host of other challenges to deal with besides: a lack of secondary market liquidity anywhere outside Malaysia; the damning remarks recently by leading scholar Sheikh Taqi Usmani from Pakistan, who said 85% of non-ijarah sukuk issues were not in compliance with Shariah law, undermining the credibility of the entire industry; and divergent standards on compliance between the Middle East and southeast Asia. Issuance more than halved between 2007 and 2008, to $15.4 billion, although it did rebound to $16.2 billion in the first three quarters of 2009; issuance is driven by southeast Asia rather than the Middle East, with the Gulf nations accounting for only 16% of issuance in the first half of 2009.

But despite this continuing lack of clarity about rights and processes, the market itself will no doubt persevere. In particular, few in Malaysia – whose US$66 billion of outstanding public and private sukuk at the end of June 2009 accounted for 62% of the total outstanding sukuk globally, according to Bank Negara Malaysia – feared much contagion even when a default was on the cards. “The Malaysian ringgit sukuk market will be isolated from this incident,” says Abdul Ghani. “It’s a domestic market with its own framework, its own infrastructure, its own investor base. It’s the most mature sukuk market and its activities have been tested in court, in restructurings and reschedulings since 1990.” He did, though, expect dollar sukuk issued from Malaysia to struggle to tap Gulf investors “as most of them have been affected by Nakheel.” For its part, Bank Negara Malaysia told Asiamoney a default, if it came, would be “a credit issue on a particular issuer” with “no systemic impact on the Islamic capital market” and “no adverse impact on the overall sukuk market in the long run.”

That said, the market will evolve. Ernst & Young expects more sovereign issuance, including European and Asian issuers such as the UK and South Korea; others say investors are likely to show a preference for those from wealthy companies with assets to back them – such as oil for Abu Dhabi, and gas for Qatar. Efforts are likely to increase to build secondary market trading in sukuk – Saudi Arabia is already trying this by introducing sukuk trading on the Tadawul stock exchange, and the Islamic Development Bank proposes to launch an investment bank to create an Islamic interbank market. And, more than anything, even if Nakheel’s survival has deprived the market of a chance to learn more about creditor rights, the future must involve an evolution of structures that makes these things more clear. “There is going to be an increased push for transparency and better governance,” says Kronfol.

But today, the whole market looks tarnished. As Asiamoney went to press, the great and the good of the Islamic finance industry were meeting in Bahrain for the landmark annual World Islamic Banking Conference. “We were expecting to be able to celebrate the triumph of Islamic finance over conventional,” says one person in attendance. “In the last year most Islamic bankers have been saying: ‘look at us, if people had worked with us they wouldn’t have lost any money’. Well, nobody is saying that right now.”

BOX: Dubai

Sheikh Ahmad Bin Saeed Al Maktoum, the chairman of the Dubai Supreme Fiscal Committee and uncle of Dubai’s ruler, had some soothing words to say when he announced the $10 billion bailout of Dubai World on December 14. There was talk of “our strong commitment as a global financial leader to transparency, good governance, and market principles.” He wanted to “reassure investors, financial and trade creditors, employees and our citizens that are government will act at all times in accordance with market principles”. And he promised: “Our best days are yet to come.”

It is to be hoped so, because the two weeks prior to his statement are never going to appear in any précis of Dubai’s best days. Credit and stock markets worldwide were delighted at the news, but that doesn’t mean are going to forgive Dubai’s conduct in a hurry. That’s going to matter when Dubai comes to refinance its other debt.

One of the biggest complaints that came after the announcement of the standstill was that people felt misled: that they had assumed the state would stand behind its subsidiary companies. Nakheel – “where vision inspires humanity”, as its tagline continues to trumpet – is the backer of the vast palm-shaped property developments that are sprouting into the Gulf, among the most iconic projects in this most ambitious of cities. Nakheel, in ownership and symbolism, is Dubai.

In fact, the 237 page prospectus for the sukuk itself contains no mention of state backing, which has led some to question the wisdom of investors and rating agencies in their approach to assets like the Nakheel issue. “As there were various risk factors listed in the Nakheel sukuk prospectus, a clear statement that Dubai World depends on its subsidiaries, and none actually giving any indication that the Emirate of Dubai would pay for Nakheel in case of insolvency, the original rating based on implicit sovereign support seems to be exaggerated, and not really wise,” says Michael Salah Gassner, a banker and founder of the website islamicfinance.de.

On paper, that’s clearly true, but what muddied the waters was the apparent statement of support from Dubai’s leadership – right up to Sheikh Mohammed – in the weeks and months before the standstill announcement. “A few weeks ago Sheikh Mohammed publicly said the Dubai economy was in good shape and he didn’t expect any more problems for it,” says Douglas Hansen-Luke, CEO for the Middle East at Robeco in Bahrain. “I am sure there are no records anywhere of him explicitly guaranteeing the debt of companies in which he is the largest shareholder. But at the same time there are no explicit statements until these last two weeks that he would not stand by them. And it would certainly be true to say that the vast majority of the investment community thought they were almost pari passu.” And, in the end, it appears it was.

Hansen-Luke stresses there is another side to the coin. “The ruler in Dubai has got the opportunity to show two things – one, that Dubai is a normal economy, where companies that invest soundly and are in the right markets will do well, and companies that don’t will become smaller, restructure or close – that’s the nature of capitalism. It’s good for people to see this is a capitalist economy and nothing is too big to fail: that is a positive message. The other is that Sheikh Mohammed will not tolerate corruption or wrong-doing. That’s also very positive for the long term future of Dubai. But to get that right in the near term, a third element is needed, which is transparency.” And this is really where the greatest hand-wringing is taking place: the sense of being surprised, of being in the dark.

This is only the first stage of Dubai World’s restructuring so there is much to be worked out. “This really is a key moment in Dubai’s evolution,” says Khalid Howladar at Moody’s. “If it hopes to retain and improve its position as a financial centre it needs to show fairness and transparency in its restructuring.”

One thing in particular infuriates foreign investors: that the standstill was announced immediately before a four-day public holiday, letting uncertainty and rumour drive world markets until Dubai got back to work. And the bailout, when it came, was a matter of hours before the sukuk would have entered technical default. Investors don’t like a white knuckle ride like that, particularly on what they thought was state-backed paper; many will doubtless think twice before rushing back to Dubai.

“The direct impact of the standstill and the relatively small amount of money involved,” says Hansen-Luke, “is much less important than the impact on perception and credibility.”

 Nizam Yaquby, Shariah Scholar

If you want an illustration of the growth in Islamic finance over the last 10 years, forget bankers: look to the scholars.

 Here, a whole new profession has evolved. People who buy Shariah products or put their money in Shariah bank accounts need to be sure that what they are buying or investing in is Islamic. Shariah scholars provide this endorsement – and in so doing, have become some of the most powerful, prized and scarce people in the industry.

 The bottleneck in the development of scholars who are schooled in law, understand finance, realise where businesses are coming from and are proficient in enough languages to explain it all, is one of the biggest challenges in Islamic finance. Until it is redressed there is a slender elite of barely half a dozen names who appear with remarkably regularity on the advisory boards of the world’s Islamic institutions. Just how big that industry is will forever be in dispute, but we do know, for example, that the 100 biggest Islamic banks had US$580 billion in assets at the end of 2008 – and that was a 66% increase on the previous year despite the global financial crisis. A big industry to be policed by so few.

 The most well-known of them all is Sheikh Nizam Yaquby, the Bahrain-based scholar who is believed to serve on more than 40 Shariah boards from Citi Islamic and HSBC to Abu Dhabi Islamic Bank and the Dow Jones Islamic Index. Operating for years out of a desk at the back of an electronics store in the Manama souq, he exemplifies the speed with which the Shariah advisor role has evolved from fusty scholarliness to a jet-setting profession on a par with commercial law.

 Sheikh Nizam is also probably the most widely-recognised of the scholars, forever on the road addressing conferences to improve knowledge of Islamic finance and of the Shariah scholar discipline. Strong voiced and sometimes strident, particularly if people challenge him on what scholars get paid these days, he is also considered at the cutting edge of financial innovation.

 But – and this is also a characteristic of this new profession – this embrace of innovation is something of a double-edged sword. Nizam and his peers, like Mohd Daud Bakar in Malaysia and Yusuf Talal Delorenzo in the USA, have become known as commercially-minded scholars, for their ability to understand the most complex structures and the way they work in financial markets. But some feel that some of the products that have been approved by these scholars run perilously close to breaching the spirit of Shariah, whether it be an Islamically compliant hedge fund or the tawarruq or reverse murabaha structure, which the OIC Fiqh Academy as declared non-compliant.

 “There is no perception among Scholars that there is one more conservative and one more progressive,” Nizam once told the author. “These are terminologies used by outsiders. Within our Islamic legal community different scholars reach different conclusions for different reasons… Yes, in the last five or 10 years more conventional products are being designed in a way to be acceptable from a Shariah point of view. I believe if it is properly done, with proper approval and procedure, there is no harm in that, in giving Islamic bankers and investors more tools.”

 Despite reservations about whether scholars act as the guardians of the industry or seek to find ways to let borderline structures through, the fact is Islamic finance can’t thrive without Shariah scholars, and their practice needs to be recognized and developed. Nizam will be recalled as one of the pioneers of a new profession.

To see how the article ran, click here: GFPsupplement 4

The idea of capital protection is well entrenched in Islamic asset management, and with good reason:  the wild behaviour of some stock markets in the Muslim world, and particularly in the Gulf, makes a safety net a very desirable companion in an investment strategy.

But although today’s battered markets create the sort of environment in which capital protected product launches usually flourish, new products are proving thin on the ground – partly because of the same concerns about structuring that apply in the developed world, and also because of doubts about how capital protection fits with Shariah compliance.

Capital protected structured products have been available in Islamic finance for many years. HSBC, for example, has sold such products for at least seven years; its HSBC-Link Ethical Capital Protected Fund, sold in Singapore, has been running since 2002.

But one could argue the golden age of Shariah capital protected products came with the huge crashes in Gulf stock markets in 2006, and the period thereafter. The Gulf was already the market with the greatest penetration of Shariah funds – in Saudi Arabia they account for more than 70% of the national mutual fund industry by assets – so it was a natural home for Shariah capital protected products to be developed. Investors certainly felt a need for them: both Saudi and the United Arab Emirates saw their stock markets halve in the space of a few months that year, and while the bottom of such a crash is rarely the best time for investors to seek capital protected products, history shows us that that’s exactly when they tend to sell.

A few examples show how local banks and fund managers quickly grasped the trend. In October 2006 Bahrain’s Khaleej Finance and Investment launched a capital protected fund called Optimum, linked to Islamic equities, crude oil and copper. Deutsche provided the capital protection. In March 2007 Dubai Islamic Bank launched a series of capital protected global real estate investment trust (REIT) notes, investing in the US, Europe and Japan. The following month ABN Amro launched an Islamic capital protected note in the Gulf linked to a basket of commodities, one of a series of Islamic notes from the bank. And in May that year Bahrain’s Shamil Bank launched a 100% capital protected Islamic fund, linked to a basket of global equities and commodities. A three-year product, it is due to pay out next year, and was structured by BNP Paribas.

Outside the Middle East, capital protected options have grown in popularity too. In Malaysia, for example, ING’s Baraka series are capital protected notes linked to global equity markets; CIMB is another Malaysian manager offering protected products from its Islamic range. In Pakistan, Al Meezan Investment Management launched the country’s first Shariah compliant capital protected fund in February 2008, putting up to 80% of the fund into a murabaha structure with Meezan Bank and the balance in Shariah compliant equities.

So there is a track record of these structures all over the Islamic world. But as yet, there has been no wave of new product launches with the fanfare one would expect in such an environment, promising safety of capital. Why not?

One reason is that structuring has become a dirty word in the conventional markets, and some of that reputation has washed over to the Islamic world as well. While many local institutions sell capital protected products, it’s very often an international group like Deutsche, UBS, JP Morgan, BNP Paribas, ABN Amro or SG who’s behind it – and none of those groups are particularly active in structuring at the moment, recognising the dire consequences that have come of some of the structures they have been selling in the conventional world in recent years, and the difficulty in selling them again in the short term.

A broader issue is the role that structuring and capital protection can play in Islamic finance anyway. Shariah law prohibits speculation and unreasonable uncertainty. It also, though, requires a certain level of risk – this is why conventional deposits can’t work in Islam, because money can’t just turn into more money without serving some broader function, such as trade. Guaranteeing a return of capital is not, strictly speaking, Islamic; some practitioners suggest that it’s more appropriate to consider it a promise to do one’s best not to lose the money (though that’s hardly a marketable approach).

Author’s note: to see the published article, including tables and data, follow this link: http://www.euromoney.com/Article/2060579/BackIssue/65745/Islamic-finance-Size-will-matter-in-Islamic-banking.html

As you read this, someone, somewhere, will be addressing an Islamic finance conference and stating with pride that there are 300 Islamic banks operating in the world today. But this statistic, ubiquitous in presentations about the growth of Islamic banking, is not an entirely positive number: it’s far too many.

Islamic banking is enormously fragmented. At the top end, there are a handful of institutions of truly significant scale: Al Rajhi Bank, with US$33.3 billion of total assets as of 2007; Kuwait Finance House, with $32.1 billion; and Dubai Islamic Bank with $22.8 billion. (See the attached data from IFIS for a more detailed breakdown.) But after that, there’s daylight, and you don’t have to go too far down the list to get to the minnows.

Numbers are notoriously tricky to pin down in this field but in a January study the IMF put total Islamic banking assets at $250 billion, citing several other studies. That’s an average of less than $1 billion of assets per bank, and with the best part of $100 billion taken out of the picture by the top three alone, one can see that there are a large number of banks with very little to their name. “They say that something like 65 to 70% of Islamic institutions are capitalised at less than US$25 million,” says Agil Natt, CEO of the Malaysia-based Islamic finance training organisation INCEIF, and formerly head of Aseambankers and deputy chairman of Maybank. “That’s nothing.”

“Moving forward, not only do you need balance sheet, but you need reach and the power to distribute the various instruments that you come up with,” Natt says. “My opinion is there is a need for a few large Islamic financial institutions with global reach, but the industry has not reached that stage.”

There are the earliest signs of consolidation taking place. This year Maybank bought a 20% stake in Pakistan’s MCB Bank for US$686 million. However, despite the name (MCB stands for Muslim Commercial Bank), it is not actually an Islamic bank: in fact, only 8 of MCB’s 1026 branches at the time of the acquisition were dedicated Islamic branches. Parties on both sides of the deal talked about working closely on Islamic banking, but this was more of a conventional tie-up with Islamic side-effects.

One could say the same of the full merger of National Bank of Dubai and Emirates Bank: while there is an Islamic entity within the group (Emirates Islamic Bank), and both banks sell Shariah mutual funds, this is again a merger of conventional entities which happens to have an impact on Islamic subsidiaries. Likewise Malaysia’s CIMB Islamic, which runs Islamic banking and asset management operations in Indonesia through Bank Niaga: a cross-border presence, certainly, but one which sprung out of the 2002 purchase of one conventional institution by another, both of which happened to have Islamic subsidiaries or licences.

Without question, there have been signs of Islamic banks becoming more globally minded, but they have tended to do this through organic expansion. The clearest example is in Middle Eastern institutions heading to Malaysia, notably the big two of Al Rajhi and Kuwait Finance House. They have taken advantage of Malaysia’s policy to open its doors to foreign entrants in order to establish itself as the global hub for Islamic finance, with KFH opening officially in February 2006, and Al Rajhi a year later. A third bank followed: Asian Finance Bank, which at the time of launch was owned 70% by Qatar Islamic Bank (the fourth largest Islamic bank in the world, according to IFIS data), 20% by Saudi Arabia’s RUSD Investment Bank, and 10% by Kuwait’s Global Investment House.

For KFH, the Malaysia expansion – which has been followed this year by the licensing of an Islamic asset management business – was in keeping with a long-standing and against-the-herd policy of global engagement. Indeed, until recently one could have argued that KFH was the only Islamic bank anywhere to have expanded cross-border to any meaningful degree. It holds a majority stake in Kuyevt Bank, an Islamic bank in Turkey, and has operations in Bahrain, Algeria, Saudi Arabia and Morocco and affiliates in the United Arab Emirates, Oman and Bangladesh. Its first participation in Malaysia came back in 1995 when it set up a leasing joint venture with several Malaysian partners and the Islamic Development Bank; around the same time it applied for a full Islamic banking licence from Bank Indonesia, although the Asian financial crisis put that on ice.

Viewed from a distance, the Middle Eastern property industry is symbolised by Dubai. That’s the place with the fastest pace of development, the tallest buildings, the wackiest plans for world-shaped islands and underwater hotels. It may be as brash and bold as Las Vegas, but it’s not the whole story. Outside Dubai, and even beyond the booming cities of Abu Dhabi, Doha, Kuwait City and Manama, there are other interesting real estate stories. With concern growing about overheating in Dubai property, they’re starting to look like more attractive propositions.

At the heart of this momentum is money from the Gulf itself. For some time, Gulf developers have been looking for new opportunities. Jordan, Oman and Egypt have captured particular attention, with some looking as far afield as Lebanon, Morocco, Tunisia and Syria. All the big names in Gulf property development – Dubai’s Emaar and Damac, Qatari Diar, Bahrain’s Gulf Finance House as well as the big Saudi and Kuwaiti conglomerates – are aware of the risks of concentration in one market and, more importantly, see great long-term gains to be had in less well-trodden locations. The only question now is: in the new, more frugal environment that must follow the credit crunch, can they all be funded?

“You cannot invest your whole capital in GCC, because the economy is not so large,” says Faisal Hasan, head of research at Global Investment House in Kuwait. “With the liquidity GCC has, even with the decline in oil prices, they are still looking at investing their surpluses outside. The MENA region is one they understand and you can also see substantial appreciation in it: the latest IMF report says MENA will grow at 5.5% at a time when other markets are in recession.”

It’s natural that developers are looking beyond their home markets. Whether or not you think Dubai and other centres are bubbles waiting to burst [and see the news story on page xx for a discussion of falling prices in the luxury residential sector], nobody could claim they are cheap. “Prime rents continue to demonstrate unprecedented increases,” says Mohammed Faheem at CB Richard Ellis in a third quarter 2008 review of Dubai’s office market. Prime office rents are going for between AED5650 and 5920 per square metre, a 38% year on year increase, and are unlikely to fall any time soon: “With no new office supply anticipated, prime CBD rents are likely to appreciate further during the remainder of 2008.” Renting or purchasing prime office space or land has become prohibitive in Kuwait City, Abu Dhabi and Doha as well. And, while Gulf investors are historically quite happy to invest in the US, UK and Europe, they are increasingly happy to invest in their own region too – a trend seen all the way from the high-net-worth individual to corporates and sovereign wealth funds.

The problem is that this expansion into overseas markets has come at exactly the same time that sources of wealth for the big developers are drying up. The credit crunch took a while to arrive in the Gulf, but it has certainly turned up now: for the first time, the Dubai government, and others in the region, are talking about scaling back their construction ambitions. That suggests a rather less rosy underside to some of the brochure pictures of soaring blocks in azure skies.

“Most of the market in GCC is in flux now,” says Bikash Rout, senior financial analyst at Global. “People are really scrabbling for liquidity, not looking for new investments. It’s not that they’re exiting Dubai and going to Oman, they’re selling in Dubai and trying to preserve their capital. You won’t see people taking much interest in new projects, as most of them are facing some kind of liquidity crunch.”

After all, it’s not as if these new projects in Egypt and Oman have suddenly sprung up overnight. The landmark developments in these countries long predate the price dynamics of Dubai or Kuwait. “These are developments which started a few years back driven mostly by demand for real estate facilities on the back of growing economies and strong demographics, as well as opening up to tourism,” says Bassam Al Othman, senior vice president at Markaz in Kuwait. “I don’t see developers from the Gulf investing new capital in these countries.” Instead, he feels developers are more likely to take their next step into deeper markets such as Abu Dhabi, Qatar and Saudi Arabia if correcting prices reveal new opportunities. “Real estate investors are in a wait and see mode, trying to play it safe until the dust of the global financial crisis has cleared,” he says. “Would we see investors migrating to areas which had lower attention in the past few years? That is doubtful. I would assume that investors will become more risk averse and will focus on places with the strongest fundamentals.”