Western investors watch nervously as worth of Islamic bonds is tested to limit

[FarCenter]

A DEFAULT by Dubai will put the world of Islamic finance to the test at a time when hard questions are being asked by bankers and lawyers about the protection afforded by financial instruments that are Shariah compliant.

The bond that lies at the heart of the threat of default and financial ignominy for Dubai is a sukuk, an instrument invented by bankers and Islamic scholars to comply with a Shariah (Islamic law) prohibition against the payment of interest on money.

Islamic finance has five pillars: a ban on interest, a ban on speculation, a ban on haram (forbidden) investments, such as pork or gambling, the requirement of partnership or sharing of profit and loss and the requirement of asset backing. Getting round the ban on interest is the problem and opportunity of Islamic finance.

A bond that doesn't (in theory) pay interest sounds unattractive but in the Gulf and Malaysia, Islamic finance has flourished over the past decade.

Typically, interest is expressed as a share in a profit, such as the rent paid for use of a property or asset. According to estimates by HSBC Amanah, the Islamic arm of the British bank, outstanding Islamic finance debt is worth $US822 billion ($902 billion).

Even Western investors have been persuaded to dip their toes in the exotic financial tool, tempted by the deep pool of petrodollars available in the Gulf. Only days before Dubai revealed its bombshell - a threat of possible default on Nakheel's $US4 billion sukuk - GE Capital, the American financial services group, issued the first sukuk by a Western company, raising $US500 million. The underpinning of a sukuk with assets makes it attractive for use in property lending or asset leasing. The sukuk issued by GE this week was a loan for aircraft leasing.

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