Chief Executive Donald Tsang Yam-kuen's plan to promote Hong Kong as an Islamic finance centre has been met with some scepticism and to attract the capital from Islamic institutions, adjustments to the legal, fiscal and taxation regimes are needed to ensure a level playing field between conventional and Islamic principles. When Mr Tsang announced his plan to develop an Islamic bond market in Hong Kong in November last year, it raised questions over whether there was enough supply and demand for Islamic bonds, known as sukuk, and other sharia-compliant products. While some sceptics have focused on local demand based on the small population of Muslims in Hong Kong, others consider Mr Tsang's rhetoric weak. If the goal is to attract the growing capital from Islamic institutions, establishing an Islamic bond market is not the best way to go. The Hong Kong government has not progressed very far when it comes to making changes to catch the attention of Islamic institutions, according to Hong Kong-based Lord Hitti, president of the Arab Chamber of Commerce and Industry, an organisation that aims to promote relations between Hong Kong, Greater China and Arab countries. These changes include adjusting the existing legal, fiscal and taxation regimes to create a level playing field for sharia-compliant principles and conventional investment principles. 'The Middle East trip that Donald Tsang made in January was not as productive as it could have been,' says Lord Hitti. 'He had a weak portfolio to present to investors over there and I don't think he met the right people. The trip was a failure as far as I am concerned.' Lord Hitti believes the Hong Kong government's laissez-faire attitude on foreign investments will not work if it wishes to encourage Islamic institutions to invest their capital in Hong Kong. Banks with Islamic banking facilities, such as HSBC and Standard Chartered, agree that Hong Kong will first need to have an infrastructure that complies with sharia law before they can conduct wholesale services to both local and international investors, including issuing debt. Special tax treatment is needed to create a level playing field for Islamic bonds and conventional bonds to make manufacturing them commercial viable. However, all these are difficult to achieve without government backing. But can developing an Islamic bond market boost the local debt market and attract abundant liquidity from Islamic institutions? 'There's a lot of liquidity in the Middle East and investors are looking for diversification and regions that have the fastest growth. Hong Kong and China are on top of their lists,' says Dubai-based Afaq Khan, Standard Chartered Bank's chief executive for Islamic banking. The Islamic financial sector is worth an estimated US$700billion to US$1trillion and it is expected to grow by 15 per cent every year. During a speech in November last year, Mr Tsang noted that assets worth more than US$300 billion were held by some 300 Islamic financial institutions in 75 countries. A further US$400 billion is managed by the Islamic business units of international banks. The Islamic bond market has shown no signs of slowing down despite the collapse of the subprime market in the United States. By the end of July last year, the total worth of outstanding sukuk was US$82.36billion, of which close to 62 per cent was denominated in Malaysian ringgit, according to a report by Moody's. Bank Negara Malaysia, the country's central bank and sovereign sukuk issuer, says that the market size may seem modest, but it has grown at an annual average rate of 40 per cent. Sukuk have become increasingly popular with investors in the past five years. This often creates supply constraints, together with massive pent-up demand, and issues of sukuk in Malaysia, Bahrain and Qatar by sovereigns and other corporates have always been oversubscribed. Unlike a conventional bond, there is a requirement for sukuk to be asset-backed in accordance with sharia principles. 'The most typical sukuk structures often involve sales and repurchase of assets, and periodic payments to sukuk investors in the form of rental payments or profit sharing. These transactions may be subject to certain tax obligations in Hong Kong, placing sukuk at a disadvantage compared to conventional bonds,' says Anita Fung Yuen-mei, treasurer and head of global markets for the Asia-Pacific region at HSBC. For example, the sales and repurchase of certain assets such as property can be subject to stamp duty, the periodic rental payment can be subject to property tax. Ms Fung says there should be some tax exemptions and special tax treatment on sukuk to make the issuance commercially viable, although she insists that such exemptions and special treatments are not intended to provide preferential treatment for Islamic bonds. As Hong Kong-listed equities outperformed most asset classes last year, the Arab Chamber of Commerce and Industry has been working on a sharia-compliant stocks index with Hong Kong stocks and H shares. Lord Hitti believes the index is likely to strike more of a chord with Islamic institutions than under the current market conditions. The Hong Kong Islamic Index is due to be launched this month and is likely to contain 78 equally weighted Hong Kong stocks and H shares. Lord Hitti says licensing products tracking the first sharia-compliant index on the Hong Kong stock market will draw in capital from the Islamic institutions who wish to invest in sharia-compliant equities. The size of the Islamic bond market makes it difficult to ignore. The British government in November last year issued a consultation on the potential issuance of a wholesale sterling sukuk after granting British banking licences to banks such as the European Islamic Investment Bank and the retail-focused Islamic Bank of Britain. Britain granted another banking license to European Finance House, a unit of Qatar Islamic Bank last month. Meanwhile, the total amount of subscriptions collected by the first retail Islamic fund in Hong Kong suggests local investors may be warming to sharia-compliant stocks and structures. Hang Seng Bank's Islamic fund attracted more than US$65million of subscriptions from the fund's launch on November22 last year till the end of the year. 'We have noticed there are just a handful of sharia-compliant funds focusing on China, a market that nobody can afford to ignore in the next five to 10 years,' says Rosita Lee Pui-shan, director and head of investment products at Hang Seng Bank investment management. She says that non-Muslim investors like the defensive China-play strategy, which excludes highly leveraged companies. The fund invests in the constituent stocks of the Dow Jones Islamic Market China/Hong Kong Titans Index which comprises the 30 largest sharia-compliant stocks that have operations in Hong Kong and China and are traded on the Hong Kong stock exchange. Not all investors from the Middle East wish to invest according to sharia-compliant principles. Sovereign wealth funds such as the Abu Dhabi Investment Authority and the Kuwait Investment Authority have invested in Citi and Merrill Lynch respectively after both banks recorded losses as a result of exposure to the subprime market last year. It is clear that starting Islamic finance and banking from scratch means that local banks and institutions will have to look internationally instead on relying on the local market to make the cost of investing in the infrastructure worthwhile. Lord Hitti estimates that out of all the liquidity held by Islamic institutions and conventional investors in the Middle East, including the oil producing countries, only 30 per cent of the total capital is invested according to sharia-compliant principles. High liquidity in the Gulf region, due to record oil prices, means that investors in the Middle East are looking for opportunities to make their capital grow. Whether it is equities or debt, to capture the capital from Islamic institutions means that an infrastructure needs to be launched as soon as possible before the cash dries up.