Islamic Capital Markets

FN5630

Project Paper: An Analysis of Capital Market

Development between Muslim and non-Muslim

Countries

(Group 2)

Prepared for: Prof. Dr. Obiyathulla Ismath Bacha

Prepared by: Murhasniyah Mukhtar (0800754)

Thaqif b. Kamaruzdin(1100286)

Mirra Nabila Mohd Sukri (1200045)

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Introduction

The capital market serves to facilitate the real sector economy by intermediating, a transfer

of funds between surplus units (investors/savers) to deficit units (real economic/business sector)

in the most effective and efficient manner1 by mobilizing savings and investments2. It has been

found that a well-developed and efficient capital market can direct resources to its best destination

with efficacy leading to development of that economy3 capital accumulation itself has been found

to be significant to economic growth4 as it is the engine of economic growth.5

This paper attempts to evaluate 10 countries, 5 Muslim and 5 non-Muslim, in an attempt

to gauge their efforts thus far towards establishing a free, fair and transparent capital market. As a

Free market that is free from capital controls and government intervention will make the capital

market of that country more attractive to foreign capital6. It does however come at the cost of being

too exposed and at the mercy of foreign investors7 should the equity held by them be shorted in a

flight. It is up to each individual country to decide whether the advantages of capital market

liberalization such as, growth in economy, diversification and development being worth the

exposure risk8. A fair market according to the Efficient Market Hypothesis would be one that

reflects the “real asset price” because the information will cause any price distortion to be corrected

immediately.9 This efficiency is good for investor confidence as it reduces the possibility of

speculative attacks and over reactions to shocks. Also, a capital market that is free and fair is good

1 (Bacha & Mirakhor, 2013) 2 (Fama, 1969) 3 (Krichene, 2013) 4 (Harrod, 1939) 5 (Krichene, 2013) 6 (Edison, Lavine, Ricci, & Slok, 2002) (Pringle, 1989) 7 (Rodrik, 1998) 8 (Quinn, 1997) (Bhagwati, 1998 (May-June)) 9 (Fama, 1969)

3

for diversification of risk making portfolio management much more effective. A capital market

can only maintain freedom and fairness should there be transparency. Without which, would stem

the flow of reliable information being transmitted to asset prices within the capital market causing

asymmetry, which can lead to speculative attacks and reduce investor confidence. Also, without

transparency, businesses are prone to take advantage as possible agency cost will rise from a

divergence of the objectives of management and shareholders and the effect is that businesses may

undertake projects with lower NPV that may just benefit the management but not the

shareholders10. Ultimately, policies do matter, but they only are effective if they are enforced.

The results are presented below by comparing between pairs of Muslim vs. Non-Muslim

countries, between each respective group and within each group over the period of 5 years. A total

of 11 indicators have been identified in performing a thorough analysis on these countries capital

market. These indicators have been grouped to three groups which are free, fair and transparent in

accommodating information for the analysis (Appendix A). Some of these indicators have been

explained by more than one groups based on the definition of the free, fair and transparent

themselves and also the elements taken into account by World Bank when constructing data.

All data is standardized by using the base of 100 and the summation in each group is

obtained before rankings are assigned and graphs are plotted. Analysis would be done based on

the three groups of indicators which are free, fair and transparent to be compared to the impact on

capital market and economy as a whole.

10 (Myers & Majluf, 1984)

4

Pair Comparison

Turkey vs. Brazil

Comparing Brazil and Turkey, Brazil’s market capitalization is larger as compared to

Turkey. For the period of 2008 to 2012, investors and entrepreneurs enjoy a more free market and

better business environment in Brazil. However, in terms of fairness and transparency, Turkey

scores higher. Hence, we can see that a free market is very important in stimulating a bigger and

more developed capital markets.

The data shows that Brazil is not as fair and as transparent as Turkey, but with the strong

economic growth and powerful policies that have been maintained since the year of 2003

reinforces investors and entrepreneur’s confidence to invest and to get their companies listed in

Brazil’s capital market. Brazil immediate recovery from the 2008 financial crisis was due to good

governance and political response. The growth in 2010 is said as the strongest in two decades11

and Brazil currently is the world seventh wealthiest country12.

Over the five years, Brazil has undergone a massive surge of capital inflow. Abundant

global liquidity and a high interest-rate differential with developed economies have

contributed to these patterns13. Internal factors such as financial-market deepening, increases in

GDP per capita and improvement in regulatory quality have also helped to attract foreign

investors14. The real has appreciated steadily ever since Lula presidency driven by capital inflows

and international financial conditions except during the 2008 financial crisis. In an effort to limit

11 (OECD, 2011) 12The World Bank, 2013 13IMF, 2010 14 (D.Furceri, 2011)

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the appreciation, the government had increased dollar reserves and introduced capital controls.15

The impact we can clearly see in market capitalization where there is vast reduction in 2011.

In case of Turkey, the market is less free based on the indicator measured and this

strengthens by the fact that Turkey previously is a state-directed economy which offers relatively

zero openness. After Prime Minister and then President turgutozal began to open up the economy,

Turkey suffers a distress period in its economy as a result of weak economic policies. Then, an era

of strong policies and framework took place brings Turkey to sustainable growth until current

account deficit in 2008 reduce the growth in economy.

Year 2008 onwards is showing a better trend in Turkey investment climate. After years of

low levels of foreign direct investment (FDI), Turkey succeeded in attracting $18.3 billion in net

FDI in 2008. Global market conditions reduced foreign capital inflows in 2009. Turkey attracted

$7.7 billion in net FDI in 2009. Inward FDI increased in 2010 to $9 billion. Rapid development of

privatization, EU accession negotiation, strong and stable growth and changes in services sector

contributed to this. Steps have been taken to improve its investment climate through administrative

streamlining, an end to foreign investment screening, and strengthened intellectual property

legislation. However, a number of disputes involving foreign investors in Turkey and certain

policies, such as high taxation and continuing gaps in the intellectual property regime, inhibit

investment. Turkey has a number of bilateral investment and tax treaties, including with the United

States, which guarantee free repatriation of capital in convertible currencies and eliminate double

taxation16. Based on the indicators, Brazil should improve the in terms of regulatory effectiveness,

15 (Michigan State University, 2011) 16 (Michigan State University, 2011)

6

regulatory quality while Turkey should pay attention to its political stability also voice and

accountability.

Malaysia-Thailand

Malaysia’s capital market is relatively large compared to its economy. It is supported by

government’s vision and comprehensive long-term planning. The market capitalization tripled in

the last 10 years and projected to double in the next 10 years. It is the ASEAN’s largest number of

listed companies and has achieved FTSE Advanced Emerging Market status and is the fastest

growing exchange in Asia. Malaysia is the Earliest in the region to implement corporate

governance reforms. Comprehensive regulatory framework provides excellent investor protection

and the financial sector in Malaysia17. Malaysian banks are well capitalized, conservatively

managed, and had no measurable exposure to the U.S. sub-prime market. The central bank

maintains a conservative regulatory environment, having prohibited some of the riskier assets in

vogue elsewhere. Malaysia maintains high levels of foreign exchange reserves and has relatively

little external debt.Malaysia ranked first in financial risk factor in the Swiss-based Institute for

Management Development World Competitiveness Yearbook 201118.

As one of the pioneers in Islamic capital market, Malaysia leads the global sukuk market.

With an inclusive framework and substantial efforts in innovating and commercialising Shariah

compliant product, Malaysia draws a distinction as an Islamic Financial Centre. Capital control

will always be the issue when dealing with Malaysia. This control which has long been

discontinued is still become the terrifying elements to investor to invest in Malaysia as it is now

presumed that Malaysia is less free and Fair. The wrong policy implemented can have far reaching

17 (Securities Commision, 2013) 18 (Securities Commision, 2013)

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implication as Malaysia is yet to achieve the same capitalization it did before 1997’s Asian

Financial Crisis and the subsequent capital controls.

The financial market in Thailand is relatively small compared to world markets. The stock

market has been growing steadily the last ten years resulting in the growth four times of its market

capitalization compared to GDP. U.S. monetary policy rate raises the U.S. interest rate, in turn,

pushes the return on the U.S. denominated asset up. This causes foreign investors to liquidate their

Thai equity investments and move their funds back to invest in the U.S. fixed income security.

The process depresses equity prices in Thailand19. This is a good example of the bad implications

effects of being Free for a small economy.

An internal factor such as political instability has greatly hindered stock market

development. The governance and policy implementation as well as supervision all suffer and are

not able to be executed as the government continuous to grapple with administrative turmoil. This

disorder affects investor and prospective investor to lay their wealth in Thailand because of the

instability and lack of Transparency. This is one of the reasons why Malaysia is doing better than

is neighbor.

According to world bank data Malaysia’s stock market has more depth than Thailand, a

significant factor to consider due to the opportunities of diversification are better in Malaysia.

Malaysia also scores higher in freedom, fairness and transparent environment indicator. Even

though Thailand is quite well known for its business fostering environment, political stability

issues have affected the economy, and indirectly stock market, adversely. Malaysia manages to be

ranked higher by The World Bank based on the strong framework and ambitious, frontward

19 (Techarongrojwong, 2012)

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government plans and the execution. Both countries show an upward trend in market

capitalization, freedom, fairness and transparent indicators, showing that these countries’ capital

markets are developing concerning their government development programs, investors’

confidence and market stability.

Egypt-India

Egypt continuous to experience domestic instability and continued political uncertainty as

a result of the ongoing volatile political and economic transition period. This depresses tourism

revenues and foreign investment, both of which are important sources of foreign exchange. Despite

efforts to make the economy more market-oriented, socialist policies continue, limiting Freedom

and Fairness with barely any transparency. Any investor would be wary of such an investment

climate. Much-needed improvements in economic policy have been delayed, and the effectiveness

of reforms that might have helped to open markets and improve productivity has been undercut by

the fragile rule of law and the legacy of Egypt’s socialist past. Deeper institutional reforms are

critically needed to spur lasting economic growth and development. Those reforms include

strengthening of the judicial system, better protection of property rights, and more effective action

against growing corruption20.

India scores larger in terms of freedom, fairness and transparency mainly because of the

Middle East political turmoil. With the strong economic growth, India is able to sustain financial

as well as capital market development. Even Indian government is shrouded by corruption problem

that heavily impacts on Fairness and Transparency, the framework formation and implementation

in financial market seems to be improved. The India’s institutional shortcomings continue to

20 (Egypt, 2013)

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undermine the foundations for long-term economic development. In the absence of a well-

functioning legal and regulatory framework, corruption throughout the economy is becoming a

more serious drag on the emergence of a more dynamic private sector. The state’s presence in the

economy remains extensive through state-owned enterprises and wasteful subsidy programs that

result in chronically high budget deficits21. However, as compared to Egypt, India provides better

environment based on the data. It is because political turmoil is so devastating that it could spoil

the whole economy stability, growth and sustainability which of course give adverse impact to the

capital market and the institutionalized indicators as well as market confidence.

Indonesia-Vietnam

By looking at the market capitalization of Indonesia, we can spot the difference that

Indonesia is particularly larger in market cap and the economy. Many businesses and investors

noted that Indonesia is well-known of its large population and plenty natural resources. But, far

fewer understand how rapidly the nation of the world’s 16th largest economy is growing. Indonesia

is booming thanks largely to a combination of domestic consumption and productivity growth.

Indonesia has an attractive value proposition. Over the past 20 years, labor productivity

improvements, largely from specific sectors rather than a general shift out of agriculture, have

accounted for more than 60 percent of the country’s economic growth. Productivity and

employment have risen in tandem in 35 of the past 51 years. And unlike typical Asian “tiger”

economies, Indonesia’s has grown as a result of consumption, not exports and manufacturing. The

archipelago nation is also urbanizing rapidly, boosting incomes22.

21 (India, 2013) 22 (Oberman, Dobbs, Budiman, Thompson, & Rossé, 2012)

10

During the past quarter century, Vietnam has emerged as one of Asia’s great success

stories. In a nation once ravaged by war, the economy has posted annual per capita growth of 5.3

percent since 1986—faster than any other Asian economy apart from China. Vietnam has benefited

from a program of internal restructuring, a transition from the agricultural base toward

manufacturing and services, and a demographic dividend powered by a youthful population. The

country has also prospered since joining the World Trade Organization, in 2007, normalizing trade

relations with the United States and ensuring that the economy is consistently ranked as one of

Asia’s most attractive destinations for foreign investors23.

After the WTO accession, Vietnam experienced a severe turmoil by having to absorb

excessive liquidity in the market due to financial crisis 2008. It drives assets prices to strike and

inflation to be peaking up24. The government then implements tight monetary and fiscal policy to

address the crisis impact which results in slumped in its free indicators group. For fairness and

transparency group of indicators, Indonesia scores higher according to the World Bank Data. This

can be explained by the development took by the government and past political history.

Iran-South Africa

Iran overdependence on oil sector, inefficient state sector and sanction put Iran’s economy

under the struggle. Although an announcement is issued in July 2006 to privatize 80% of the shares

of most government-owned companies, private sector activity is typically limited to small-scale

workshops, farming, and the service industry. As a result of inefficiencies in the economy,

significant informal market activity flourishes and shortages of goods are common. A combination

of price controls and subsidies continues to weigh down the economy, while administrative

23 (Breu, Dobbs, & Remes, 2012) 24 (Van, 2009)

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controls and widespread corruption undermine the potential for private-sector-led growth.

Inflation and the unemployment rate continue to be in the double digits. Widespread

underemployment amongst Iran’s educated youths has convinced many to seek employment

overseas25.

The Government of South Africa demonstrated its commitment to open markets,

privatization, and a favorable investment climate. South Africa's budgetary reforms such as the

Medium-Term Expenditure Framework and the Public Finance Management Act have created

transparency and predictability and are widely acclaimed. South Africa has a sophisticated

financial structure with a large and active stock exchange that ranks 17th in the world in terms of

total market capitalization. Quantitative credit controls and administrative control of deposit and

lending rates have largely disappeared helping to form a freer market. South African banks adhere

to the Bank of International Standards core standards.The South African Government has taken

steps to gradually reduce remaining foreign exchange controls, which apply only to South African

residents. During 2007, the shareholding threshold (the percentage of shareholding that must be

South African) for foreign direct investment outside Africa was lowered from 50% to 25% to

enable South African companies to engage in strategic international partnerships. In addition,

South African companies involved in international trade were permitted to operate a single

Customer Foreign Currency (CFC) account for all international transactions. Permission was also

granted to the Johannesburg Securities Exchange (JSE) to establish a rand currency futures market,

in order to deepen South Africa’s financial markets and increase liquidity in the local foreign

exchange market26.

25 (Michigan State University, 2013) 26 (Michigan State University, 2013)

12

As a result, we can see a vast difference between South Africa an Iran because of the

government initiatives. South Africa scores higher in freedom, fairness and transparency indicators

reflecting the environment in the country for investment and business which affected capital

market and showed in the market capitalization for both countries. As for Iran, the tension in the

international diplomatic relationships affects its capital market adversely.

Between Group Comparison

Market capitalization of Muslims countries seems to be lower compared to non-Muslims

countries. However, the market capitalization which is used to represent the capital markets in the

Muslims countries are less volatile as we can see from the result of 2008 financial crisis. In 2010,

the market cap for non-Muslims Countries average fall 25% due to the concern of contagion effect

from European debt crisis. The market crash like the Flash Crash 2:45 in the futures market caused

a spill-over impact in the stock market. Even the situation recover within minutes the stock markets

took longer period to recover from the crash and only experienced partial rebound. Most

importantly, it is not the time consumed to bring back the markets to its original level, but the panic

and dropping of investors’ confidence that last longer. This event took place in the States and effect

major market within a very short period of time. The Muslims countries which has smaller market

cap and less dependency on derivatives markets are affected less severely by this event.

In August 2011, Standard & Poor’s downgraded the US credit rating from AAA to AA+.

The US has been graded AAA since 1941. For the first time, the grade has fell down to AA+ and

according to Standard & Poor’s it can be lower than AA+ besides Moody’s also state a concern

that there could be possible downgrading on the government credit ratings. Severe volatility in

stock markets continues for the rest of the year again because of the European sovereign credit

13

crisis. This causes losses to both Muslims countries as well as non-Muslims countries markets.

However, the Muslims countries face less severe impact compared to non-Muslims countries

because of the size of market trading and market capitalization in relation with the losses.

Over the five years generally, non-Muslims countries experience better markets in aspects of

freedom, fairness and transparency. In 2012, we observe a huge increase in Muslims Countries

market. A lot of improvements in regulations and governments policies bring the markets towards

a more transparent market where we can see a closer convergence between Muslims and non-

Muslims countries. The development in the markets shows an augmented increase in the fairness

of the markets which results in the continuous escalation of market capitalization.

Within Group Comparison

From the data, it is noticeable that Malaysia stands out among other Muslims countries.

This can be explained by the freedom, fairness and transparency indicators measurement where

Malaysia scores higher as compared to others. This is driven by the government vision and

comprehensive long term planning, putting Malaysia as an international financial center. The

capital market is also expected to be further driven by Malaysia’s push for greater

internationalization and liberalization of its financial sector. This would bolster capital market

growth by an additional 30% in the projected size of RM4.5 trillion (US$1.5 trillion) to RM5.8

trillion (US$1.93 trillion) by 2020 with exponential benefits to Malaysia’s bond and sukuk market

segments. Bursa Malaysia, the Malaysian securities exchange, has well balanced participation with

trade values that are equally distributed among retail, domestic institutional and foreign

institutional participants. Malaysia also has the largest number of listed companies in ASEAN,

populating both the Main Market and ACE Market in Bursa Malaysia. With a comprehensive ICM

14

framework and successful track record in innovating and commercializing many Shariah

compliant products, Malaysia has established itself as an Islamic financial center27.

As for non-Muslims countries, South Africa has highest scores in institutional indicators

as measured by the World Bank. The country has the most free, fair and transparent market among

the non-Muslims countries. Across Africa there is a major focus on improving transparency and

strengthening the governance and regulatory framework in the sector. Although few countries have

opted to introduce Basel III yet, Basel II is being considered in a number of countries and

consolidation in the market could follow as capital requirements are increased in line with new

regulation. In South Africa a Twin Peaks regulatory framework will be implemented in the next

year. The Global Regulatory Reform agenda as agreed at the G20 is gaining momentum with South

African banks (Africa's largest banking market, with close on $500bn in assets) having to comply

with the Basel III principles and an increased focus on areas like Recovery and Resolution planning

(Living Wills), Treating Customers Fairly (TCF) and a renewed focus on executive

remuneration28.

In the case of Malaysia, we can see direct relationship between institutional factors with

market cap size. Malaysia’s market cap is the largest among Muslims Countries. South Africa also

has the highest market cap as compared to the country’s GDP as a result of freer, fairer and more

transparent market. In both cases, governments play an important role in pushing capital markets

to a respectable level in the world. We can conclude that institutional factor based on the indicators

measured, are the contributing aspect for capital market development.

It seems that the biggest problem facing Muslim markets is the political stability and lack

of governance in enforcing regulation and policies besides Malaysia, the best of the Muslim

27 (Securities Commision, 2013) 28 ( Ernst & Young, 2013)

15

countries. Not to mention Egypt and that seems to suffer from la lack of coherent and prudential

policies. Whereas the non-Muslim countries seem to be liberalizing their markets and gaining form

the benefits of increased investment. South Africa seems to be leading the pack of 5 with the best

improvements to becoming more free, fair and transparent. Vietnam serves as an example of a

country that is moving in the correct direction but also the dangers of liberalizing too quickly. Even

though Brazil loses to Turkey in terms of fairness and transparency its freeness helps it be in the

favor of investors and seems to be moving to overtake if they have the correct policies and

governance to drive a fair and transparent capital market.

Conclusions

The capital market is one of the most important vehicles in economy by playing the

function to channel the surplus unit to the deficit unit29.Numerous studies30 have been conducted

and concluded that capital market development leads to economic development. In this context, it

is very crucial to have an efficient government in upbringing the best policy creation and

implementation, fostering a significance market and investment environment growth as well as

utilizing potential for economic development.

In the discussion 11 indicators that have been grouped to 3 areas of free, fair and transparent

(Refer Methodology in Appendix A), and then analyzed to distinguish the impact on current

government policy and initiatives towards the capital markets.

From the analysis we can see that Malaysia stands out of Muslims countries in terms of

market freedom, fairness and transparency according to the indexes and ratings that Malaysia

29 (Bacha & Mirakhor, 2013) 30 (Edison, Lavine, Ricci, & Slok, 2002) (Bosworth & Collins, 1999)

16

scores which shows the efforts taken by the government generally. The evidence can be observed

in the market capitalization of Malaysia which is higher compared to other Muslims countries in

the group despite the issue of confidence in Malaysia market due to the capital control imposed

which has been discontinued many years back. In fact, Malaysian vision in being the international

Islamic financial center and putting efforts in the skilled labor creation, platforms formation

pioneering, policies and regulations conception should be acknowledge as noble pace towards

having a steadfast Islamic finance.

Meanwhile, South Africa is the most prominent market based on the indicators which also

shows that South African government is taking decent effort in promoting and developing the

capital market in the country. Besides the income inequalities, South African government is doing

a good job by liberalizing international trade and relationships, strengthens in financial industry

and authority and implement policies which can be drive its capital market forward.

However, Muslims countries capital markets have shown that a lot of lacking needs to be

address in our plans and policies direction in the future. The fact is Muslims countries capital

market is much smaller in size as compared to non-Muslims countries. Let alone Islamic capital

markets where not all Muslim countries have established even if the policies are outlined to do so.

Mostly Muslim countries suffer form to a lack of expertise, infrastructure and support from the

government, proper policy direction and coherence, transparency and political issues. There then

seems to be a long way before the Muslim countries can establish an international Islamic Financial

Market. An objective very desirable in promoting cross border trade and economic development

amongst the Ummah.

17

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