Chapter 8
Hong Kong
Promoting Islamic Finance in a Developing Market
Anthony Chan
Chief Executive Officer, New Line Capital Investment, Ltd.
Jess Lee
Legal and Project Development Manager, New Line Capital Investment, Ltd.
Hong Kong, which has an excellent financial infrastructure and serves as a gateway to mainland China, has the potential to be a prime destination for the development of Islamic banking products. However, to date, Islamic banking has not taken off in any substantially meaningful fashion, and neither has project financing and funding through Islamic principles, despite Hong Kong's position as one of the world's leading financial centers and mainland China's insatiable need for investment.
In the past, several Islamic financing concepts and products were introduced in Hong Kong to promote Islamic banking. For instance, Hong Kong's Hang Seng Islamic Index was developed in part to attract Islamic investors to Hong Kong's bustling capital markets and to mainland China's potentially vast but still developing capital markets. Hong Kong's Islamic index is intended to represent the performance of Shari'ah-compliant companies from both the Hong Kong and the mainland China markets.
Despite the slowness of development of Islamic finance in Hong Kong, prospects for Islamic finance remain positive. Promoters of Islamic finance, many of whom come from abroad, need to become more familiar with the Chinese compliance and regulatory regime and learn the ways and means of doing business in Hong Kong and mainland China. The manner in which business is done in this part of the world should be blended into the Islamic way of doing business.
Asset Management
Hong Kong will continue to be an attractive base for fund and asset managers and companies wishing to participate in the management of assets to tap mainland China's and Asia's many capital sources. For a number of years, Shari'ah-compliant funds have been eyeing China's market and looking for partners, especially equity or coinvestment partners for projects in mainland China or globally. Hong Kong maintains a very stable and well-regarded regulatory regime applicable to fund managers and asset managers.
There is also an active unregulated market, rather than a regulated regime under the auspices of the Hong Kong Securities and Futures Commission (SFC) and other applicable Hong Kong authorities, that is driven by venture capital or private equity. There are ample opportunities for Shari'ah-compliant institutions to locate suitable mainland Chinese and other Asian partners in Hong Kong with a view toward joint or cooperative management of funds and assets. The first Shari'ah-compliant fund for sale to retail investors in Hong Kong was authorized by the SFC in November 2007. As the SFC announced, the introduction of Islamic retail funds adds variety to Hong Kong's developing retail fund market and underscores the versatility of Hong Kong's asset management industry.
One innovative concept for attracting Islamic capital was the use of a credit union. Amwal Credit Union, Hong Kong's first and only Shari'ah-compliant cooperative financial institution, was set up and began operation in 2009. Amwal Credit Union sees itself as a role model for the development of credit unions in the parts of Asia that have large Muslim populations. This includes mainland China, which ostensibly has the world's third largest Muslim population. Such a financial institution would identify and implement creative ways for Muslims to adhere to religious restrictions that permit members to share in profits made from investments rather than earning interest on loans.
For example, credit unions pay dividends to their members, which means that the members participate in the success of their credit union. Moreover, loans granted by credit unions to their members are generally required to benefit society. Thus, making a profit serves to reduce the operating costs of the credit union and pay a return to the members. It is hoped that in time the primary aim of Amwal Credit Union will be successfully achieved with profitable returns to members under Islamic principles. Amwal Credit Union is currently Hong Kong's only homegrown financial institution that provides financial services and conducts business in accordance with the tenets of Shari'ah.
Tax
Taxation concerns are a major issue in the promotion of Islamic financial products in many jurisdictions. Hong Kong is no exception.
For instance, profit (coupon) payments made to sukuk holders from the economic return of the assets are not treated as interest payments and hence are not tax-deductible for the issuer. Depreciation allowances could not be claimed because the underlying assets are held by a special purpose vehicle and not by the originator itself. On July 19, 2013, the Inland Revenue and Stamp Duty Legislation (Alternative Bond Schemes) (Amendment) Ordinance 2013 came into operation. It amends the Inland Revenue Ordinance and Stamp Duty Ordinance to provide a taxation framework for Islamic bonds, or sukuk, promoting the development of a market for these bonds in Hong Kong.
The secretary of financial services and the treasury noted that the amendment ordinance represented the joint efforts of the government and the market to remove impediments to developing a sukuk market in Hong Kong. The government believes that this will help establish a conducive platform for the development of Islamic finance in Hong Kong, thereby diversifying the types of products and services available to its financial markets and consolidating its status as an international financial and asset management center.
Given that Hong Kong's economy is inextricably linked with mainland China's, so are the respective tax regimes of the two jurisdictions. With so many business operations and assets of Hong Kong enterprises spread throughout mainland China, the success on the rollout of any Islamic financial product will depend not only on Hong Kong's tax treatment of such products but also on mainland China's treatment. The latter is especially important because mainland China has a substantial number of Muslims, and Islamic finance can act as a catalyst to the economies of the western provinces.
Retail and Microfinance
On June 27, 2013, the Islamic Financial Services Board (IFSB) organized, and the Hong Kong Monetary Authority (HKMA) hosted, a seminar entitled Strategies for the Development of Islamic Capital Markets to promote discussion, understanding, and experience sharing in the area of Islamic capital markets. This seminar was particularly timely and relevant in view of the growing interest in Islamic finance in Hong Kong and at a global level. The secretary-general of the IFSB commented that Islamic finance had displayed remarkable growth over the years, adding that the mandate of the IFSB was to assist and facilitate the building of the supporting financial infrastructure not only for Islamic banking but also for other segments of the industry, including Islamic capital markets, Islamic insurance (takaful), and lesser-value financial products.
It is anticipated that if Islamic financial products were developed in Hong Kong, larger-value products, such as sukuk issuance or large-scale project funding, would take practical business precedence over products aimed at retail or microfinance. Nonetheless, retail, microfinance, and so-called lesser-value financial products should not be disregarded. Hong Kong is starting to pay serious attention to the tenets of microfinance.
Even though non-Islamic in nature, the Hong Kong Mortgage Corporation Limited launched the Microfinance Scheme in collaboration with six banks and five NGOs in June 2012. The scheme offers three types of loans: micro business start-up loans, self-employment loans, and self-enhancement loans to assist people who wish to start their own businesses, become self-employed, or achieve self-enhancement through training, upgrading skills, or obtaining professional certification. The scheme provides supporting services, including mentorship and entrepreneurial training, to business starters and the self-employed on an as-needed basis.
The maximum amount for the loan in each of the three categories, respectively, is HK$300,000, HK$200,000, and HK$100,000. The maximum loan tenure is five years, with an annual interest rate of not more than 9 percent for general borrowers and not more than 8 percent for borrowers who can provide a third-party guarantee. Borrowers may also enjoy a principal repayment holiday for up to 12 months. With this head start, it is hoped that the Hong Kong Mortgage Corporation or another appropriate institution could take the initiative on Islamic microfinance using some of the principles and lessons learned from the new product as a guide.
Islamic Banking
In order to support the government's initiative to develop a platform for Islamic finance in Hong Kong, the HKMA recognizes the need to clarify its regulatory approach to such activities. Existing authorized institutions may participate in Islamic finance activities through two organizational forms. First, they may operate a separate business unit within the institution itself, with the unit's operations based on Islamic law. This unit is commonly known as an Islamic banking window.
Alternatively, they may establish and operate a subsidiary for the sole purpose of conducting Islamic financial business. If such a subsidiary is to be involved in banking or be a deposit-taking business, it will be required to obtain an authorization from the HKMA under the Banking Ordinance. Overseas Islamic banks may apply for an authorization under the same ordinance for the establishment of a branch in Hong Kong.
An Islamic banking window is a business unit within a conventional authorized institution, usually a bank, that enables the institution to offer Islamic financial services through its existing infrastructure and branches. Therefore, it can be established quickly and at a relatively low cost. From a market perspective, the setting up of Islamic banking windows by existing authorized institutions can be seen as an efficient way to attract those who offer Islamic financial services, which will be crucial in developing Hong Kong's Islamic finance platform. As such, Hong Leong Bank was the first bank in Hong Kong recognized by Malaysia's central bank and the HKMA to launch its Islamic banking services, on August 18, 2008.
An institution that proposes to establish an Islamic banking window is not required to obtain a separate authorization under the Banking Ordinance. However, the institution should discuss its plan with the HKMA before launching the window. The plan should be credible and based on realistic assumptions in relation to the particular nature of the Islamic financial operation. The discussions between the institution and the HKMA include the following topics:
- The authorized institution's risk management processes to ensure that the risks inherent in the Islamic financial products offered by the Islamic banking window are well understood, assessed, monitored, and controlled.
- The authorized institution's policies, procedures, and controls to ensure that the products are Shari'ah-compliant.
- The preparation of the contractual documentation underpinning the Islamic financing transactions to minimize legal disputes.
- The proper disclosure of risk and return to depositors.
These issues will also be applicable to the evaluation of an application for separate authorization under the Bank Ordinance for an institution that seeks to specialize in Islamic financial activities.
Risk Management
Whereas conventional banking is based primarily on an interest-based debtor-creditor relationship, Islamic financial transactions are more complex, given the diverse contractual relationships between the banks and their customers, ranging from lease-based to equity-based modes of finance. Therefore, a new Islamic banking product or service should be subject to careful evaluation and preimplementation review by the authorized institution. This is to ensure that the board (or its designated committee) and management fully understand the risks inherent in the new product or service and that there are adequate staffing, technology, and financial resources to launch and support its operation.
The general process of evaluating an Islamic product or service before its launch is similar to that for a conventional product. A proposal to introduce the new product or service should include a full description, a detailed risk assessment, a cost-benefit analysis, consideration of the related risk management implications and identification of the resources required, an analysis of the proposed scale of the new activities in relation to the bank's overall financial strength, and the procedures to be used for measuring, monitoring, and controlling risks. Appropriate internal consultation, including legal and compliance aspects, should be carried out regarding the proposal.
Adherence to Islamic Law
Banks are responsible for ensuring that Islamic products or services are Shari'ah-compliant both before and after launch. It is important to maintain the integrity of the products and to avoid possible subsequent disputes. The effective monitoring of Shari'ah compliance can be done through the appropriate internal Shari'ah auditing processes and by developing more knowledge and expertise among the staff.
As an industry practice, a new Islamic financial product or transaction should be reviewed by a bank's Shari'ah supervisory board to declare the product or transaction's compliance. In approving the establishment of an Islamic banking window or a new product to be launched by the window, the HKMA, being a secular regulator, does not review the role or composition of the Shari'ah supervisory board, nor does it express an opinion on the validity of that board's recommendations and decisions. However, the HKMA expects that the basis on which a bank claims that its products or services are Shari'ah-compliant will be clearly communicated to its customers.
Binding Documentation
It is generally understood that the enforceability of an Islamic financial contract is dependent on the governing law of the contract. Therefore, it is advisable that contracts for Islamic financial transactions should be carefully written to minimize potential disputes and should clearly set out the governing law of the contract.
Disclosure of Risk and Return to Depositors
Deposits placed with a bank with an Islamic banking window are mainly in the form of investment deposits. The depositors adopt the role of quasi-shareholders who are not only entitled to share in the profits of the Islamic banking business but are also exposed to the risk of losing their capital in the event of losses. As matters currently stand, investment deposits are not regarded as protected deposits under the Deposit Protection Scheme Ordinance or the temporary deposit guarantee by the Exchange Fund announced on October 14, 2008. Improved financial disclosures on the risk and return profiles of the different categories of deposits, as well as their status under the Deposit Protection Scheme Ordinance, will enable depositors, potential or otherwise, to make informed decisions.
A significant and growing volume of the business generated in Islamic finance has taken the form of Shari'ah-compliant asset or equity-based securities known as sukuk. Consistent with its role as an international financial center, Hong Kong is taking steps to develop its own sukuk market. Hence, it is useful to clarify the regulatory principles and treatment for holdings of sukuk, particularly for capital adequacy, large exposure, and liquidity requirements.
The HKMA's supervisory policy for holdings of sukuk is based on the principles of a level playing field and economic substance. The supervisory standards to be applied to authorized institutions' exposures to sukuk will be the same as those applying the conventional equivalents. In deciding on specific supervisory treatment, the HKMA will consider whether sukuk, regardless of their legal form, can be regarded as the economic equivalent of conventional bonds. This determination will govern how sukuk should be treated under the existing law and regulations.
For example, many sukuk may superficially resemble securitization transactions because of the existence of a pool of underlying assets that generate cash flow for repayment, but in substance their investors can rely only on the ultimate obligor of the sukuk for repayment, with no recourse or limited recourse to those underlying assets. Consequently, applying the regulatory requirements for securitization in such cases would be inappropriate. The HKMA is developing its supervisory policy on sukuk and other Islamic finance activities by reference to the guidance issued by ISFB and regulators in major Islamic jurisdictions to ensure that its policy is appropriate to the risk exposures in such businesses and activities and in line with international standards.
For capital requirements for credit exposures to sukuk, authorized institutions are expected, at this point, to calculate the necessary capital charge based on the standardized (credit risk) approach set out in the banking (capital) rules. This reflects the early stage of development of the sukuk market in Hong Kong and the need to accumulate sufficient historical data before applying the internal ratings-based approach to such activities. Although there may be cases in which the capital treatment will vary according to the structure of a given sukuk issue, institutions in general should treat sukuk as conventional bonds and risk-weigh them in accordance with their external credit assessment institution rates.
The IFSB capital adequacy guidance provided for a transparent approach for unrated issues. As this approach is not permitted under the current banking rules for nonsecuritization exposures, it will not be made available to authorized institutions for sukuk issues in order to maintain a level playing field. If a particular issue of sukuk is regarded by the SFC or an overseas regulator as a collective investment scheme, exposures to the sukuk should attract the appropriate risk-weighing treatment for a collective investment scheme as set out in the banking rules.
Sukuk and Renminbi Business
Sukuk continues to be one of the most prominent instruments employed in Islamic finance. Strong global growth has occurred in the Shari'ah-compliant securities and sukuk market. Sukuk issuances reached US$131 billion in 2012, a 54 percent increase over 2011, and are expected to have reached new heights in 2013.
Since the payment and receipt of interest is prohibited under Islamic law, sukuk is often structured in a way so as to generate the same economic effects as conventional bonds but in a Shari'ah-compliant manner. Sukuk has more complex product structures than its conventional counterpart, since it is usually structured with special purpose vehicles, multiple transfers of assets, and various contractual techniques.
Although sukuk arrangements are economically equivalent to a debt arrangement, the prohibition of interest payments and multiple transfers of assets would lead to additional Hong Kong tax exposures for the parties involved, compared to those of a conventional debt arrangement, thus resulting in an impediment to developing the sukuk market in Hong Kong.
Since 2007, Hong Kong has been looking for ways to encourage the development of a sukuk market in Hong Kong, which has historically been limited by the potentially adverse tax treatment of such instruments. If the tax regime is changed pursuant to legislative changes (see “Tax” section earlier), sukuk issuers and investors will no longer be subject to additional tax and stamp duty charges. Therefore, the passage of the Amendment Ordinance in July 2013 was a very positive step forward in the development of Islamic finance in Hong Kong.
Another area that may see major development in the Hong Kong Islamic finance sector relates to renminbi-denominated sukuk issues. Being the leading offshore renminbi market and a special region of its motherland, Hong Kong provides a unique opportunity for Islamic investors to invest in renminbi-denominated sukuk. The availability of renminbi bonds and sukuk, as well as other financial products for portfolio investment, not only encourages renminbi receivables but also helps build a pool of trade-driven renminbi liquidity in the market.
It is therefore likely that there will be a market for renminbi-sukuk bonds in the future. This is especially the case in light of the voracious appetite of mainland China's enterprises to raise debt in Hong Kong and to always look for competitive and innovative ways to do so.
Debt Capital Markets and Equity Capital Markets
The size of Islamic finance assets globally has expanded from US$150 billion in the mid-1990s to US$1.6 trillion in 2012. The global sukuk market is still growing. According to some market estimates, the size of the global Islamic finance industry has the potential to increase five times from the current level to some US$6.5 trillion by March 2020.
Hong Kong has historically been a fundraising center for Chinese enterprises, and now it needs to maintain its position through innovation and new product development. To this end, the development of renminbi-denominated investment products appears impressive. In the short space of six years, the size of the renminbi dim sum bond market in Hong Kong has grown from 10 billion yuan in 2007 to 237 billion yuan at the end of 2012.
Offshore renminbi financial products have also become more diversified, expanding from renminbi bonds alone to renminbi equities, investment funds, A-share exchange traded funds, and insurance products. In addition, Hong Kong possesses the largest renminbi liquidity pool outside mainland China. By the end of 2012, the aggregate amount of renminbi customer deposits and certificates of deposits had reached a high of 720 billion yuan.
The growth of the offshore renminbi financial markets is expected to go further, since more and more financing and investment activities will be conducted in renminbi in the future. It will be interesting to see how the fast-growing and maturing renminbi-denominated investment product market will be adapted to Shari'ah-compliant structuring to allow new Shari'ah-compliant products that are renminbi-denominated to be sold to the market.
Although Islamic banking and finance is one area of focus for Hong Kong, the ability to attract Islamic investors to Hong Kong's bustling capital markets and to mainland China's potentially vast but still developing capital markets is just as central to the building of an Islamic platform. A port of call for Islamic investors comprises the companies listed on the Hong Kong stock exchange and potentially the Chinese companies listed on mainland China's burgeoning stock exchanges, to the extent that such investment can be made pursuant to the rules relating to qualified foreign institutional investors. This is where an Islamic index (discussed earlier) becomes useful as a guide to Islamic investors. Such indexes are helpful not just to Islamic investors but also to conventional investors who invest in both Islamic and non-Islamic markets.
Hong Kong remains a global force in the equity capital markets. Many Chinese businesses continue to seek initial public offerings in Hong Kong's stock exchange. The advent of Islamic indexes will continue to assist Shari'ah-compliant investors looking at Hong Kong stocks. In particular, Hong Kong's Hang Seng Islamic Index is intended to represent the performance of Shari'ah-compliant companies in both the Hong Kong and the mainland Chinese markets. The Hang Seng Islamic Index is constructed from select companies listed on the Hong Kong stock exchange, and it includes 78 of Hong Kong's and mainland China's leading and emerging enterprises. In contrast, the Dow Jones Islamic Market China/Hong Kong Titans 30 Index covers Hong Kong–listed companies whose primary operations are in mainland China and Hong Kong.
To be eligible for the Hang Seng Islamic Index, Hong Kong–listed companies are screened for Shari'ah compliance. During the selection process, each company's audited annual report is reviewed to ensure that the company is not involved in activities that violate Shari'ah. After the companies with noncompliant business activities are removed, the remaining companies are examined for compliance in financial ratios, focusing on three areas: leverage, cash, and the share of revenues derived from noncompliant activities.
Regulatory Issues
Regarding legislative changes that must be made to accommodate Islamic financial products, Hong Kong's government has proposed “to adopt a prescriptive and religion-neutral approach, in line with that adopted by other major financial markets such as the United Kingdom, as prescriptive legislative provisions without specific reference to Shari'ah principles would provide more certainty in implementation to market players in Hong Kong,” as explained by Professor K. C. Chan, secretary for financial services and the treasury.
Currently, the legislative amendments that have been proposed cover sukuk only in its most common forms: ijarah, musharaka, mudaraba, and wakalah. Since most kinds of sukuk are in a tripartite structure comprising an originator, a bond issuer (typically a company established for the specific purpose of issuing sukuk), and a bond holder, the proposed framework is drafted based on this.
If the proposed legislative changes are implemented, financial institutions and banks will probably be encouraged to structure and provide more Shari'ah-compliant products. The reform would essentially level the playing field in terms of tax treatment with its neighboring countries and would provide a more comprehensive framework and thus more incentive to local financial institutions to offer customers Islamic banking services. Regulatory issues relating to sukuk are covered elsewhere in this chapter.
Cross-Border Financing
As an international financial center, Hong Kong has developed a highly liquid capital market with investors coming from all around the world. Moreover, with Hong Kong's unique role as a gateway to mainland China and a leading hub for offshore renminbi business, Hong Kong can offer an ideal platform to link Islamic and renminbi financing together by developing financial products that are Shari'ah-compliant and denominated in renminbi.
Many investors in the Islamic world today are actively looking for investment opportunities in Asia, particularly mainland China, in order to diversify their portfolios. Those international investors, through Hong Kong's platform, can easily enter the Chinese market. At the same time, mainland Chinese issuers can also make use of Hong Kong's platform to reach out to the increasingly wealthy investor base in the Islamic world.
In the meantime, participants in the Islamic lending market should not overlook Hong Kong's potential role in arranging and developing Shari'ah-compliant financial products aimed at Chinese enterprises and their needs as they go on the acquisition trail all over the world. This is based on the fact that many Chinese enterprises are expanding their markets around the world and are looking for investment opportunities in the areas of information technology, real estate, and mining and resources, including in the Middle East, Indonesia, and Malaysia. The need for safer and newer structures to satisfy financing needs in the acquisition of assets abroad should bode well for Islamic finance.
Conclusion
Hong Kong remains a firm favorite to meaningfully develop an Islamic finance market, given the incessant appetite for funding of its motherland. Time will tell whether it will succeed in the same way as some Southeast Asian jurisdictions have.
About the Authors
Anthony Chan was a senior finance lawyer before he established his own direct investment company, New Line Capital Investment, LLC (NLCI). Based in Hong Kong, NLCI invests directly in a variety of businesses, including oil and gas, real estate development and construction, and special opportunities arising in the Asia Pacific region.
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Jess Lee is a legal and project development manager at NLCI.
She has tremendous experience working with international law firms based in Hong Kong and Korea. She's also fluent in English, Mandarin, and Korean Language.