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Islamic finance, little affected by the global economic meltdown, faces its biggest test: a Dubai default.
In the face of a global recession, the top-100 Islamic banks saw their combined assets grow by a gravity defying 66 percent in 2008, according to figures compiled by The Asian Banker.
But the increasing popularity and credibility of Islamic finance will be put to the test on Monday when Nakheel, the financially troubled property development arm of the Dubai government, faces default on a $4 billion Islamic bond known as a sukuk.
If Nakheel does default on the sukuk, bankers and lawyers will be entering uncharted waters as they try to restructure the debt or carve up Nakheel’s assets and those of its parent company, government-owned Dubai World.
“Most of Nakheel’s borrowing is in sukuk; the failure of Nakheel would be seen as a symbolic failure of Islamic banking,” said Kassim Dakhlallah, a professor of finance at the American University in Dubai.
But Dakhlallah thinks concerns about Dubai’s financial woes have been exaggerated in the Western media, mainly because of the West’s unfamiliarity with Islamic finance and its suspicion of all things Islamic.
Nakheel, he said, appears to be going through a liquidity crisis, not a wholesale collapse, and that both Nakheel and Dubai World, still have plenty of good assets.
Nakheel, which developed the famous artificial islands shaped like palm trees off Dubai’s coast, last week recorded first-half losses of $3.65 billion, but even after writing down its real estate investments, its assets were valued at $40 billion against liabilities of just under $20 billion.
Despite the looming mess in Dubai, Islamic banks came through last year’s financial meltdown in better shape than their conventional counterparts mainly because they tended to be more conservative in their lending practices and because they avoided things like derivatives and credit default swaps, said Dakhlallah.
“They also kept a high level of liquidity on their balance sheets, which helps in a crisis,” he said.
The Islamic banking system is predicated on the Quranic injunction against the collecting or paying of interest, so the key is to devise other means of realizing the value of money over time. Often, this is a simple matter of giving it a different name — like profit or rent.
But there are significant underlying differences between conventional banking and Islamic banking. In the Islamic system, borrower and lender become, in effect, partners in a risk sharing venture. If the venture fails, both parties share the loss, which tends to make lenders more cautious.