Islamic finance has gained ground in Asia in recent years, but there is still huge potential for further growth. EM looks at the progress and outlook for sukuk across the region, as well as challenges to wider acceptance
Signs are everywhere in Asia that Islamic finance is expanding its frontiers. Hong Kong is planning a benchmark debut sukuk, Basel III compliant paper is taking off and the scope for cross-border deals is increasing.
But many Asian countries have yet to engage, while even those that have can still do much more to reap their benefits.
Malaysia has been the biggest pioneer of the modern Islamic finance industry and dominates global sukuk issuance. Malaysian borrowers account for some $490bn of the $673bn (73%) of total issued sukuk to date, according to the Islamic Finance Information Service — although $475bn of that has been to local investors.
“The sukuk market has grown fast in Asia but most of the activity has been in only one country, Malaysia,” says Thiam Hee Ng, senior economist at the Asian Development Bank. “There is a lot of potential elsewhere and we are starting to see the first signs of this developing, but more must be done if sukuk is to be seen as a viable alternative to conventional bonds and other non-Islamic financial products.”
Indonesia is another keen advocate of sukuk, both domestically and internationally, but has brought a much smaller $19bn worth of deals. Pakistan, Singapore, Brunei Darussalam and Hong Kong are also potential growth areas.
Elsewhere, the market is at best in its nascent stages and very fractured. This, however, is seen as a cause for optimism by bankers.
“New markets continue to open up in Islamic finance and it is an exciting time,” says Mohamad Safri Shahul Hamid, deputy chief executive officer at CIMB Islamic. “From country to country it is a function of credit, as some cannot issue conventional bonds yet. But if the Islamic countries are doing conventional bonds but not sukuk then one should start asking questions.”
MALAYSIA BEATS AMBITIOUS PATH
Malaysia’s Islamic Banking Act of 1983 allowed the government to issue its first Islamic debt. But its sukuk market has accelerated in the past decade, with the government making a top-down commitment that bankers say is needed for growth in other countries.
Yearly sukuk issuance out of Malaysia rose from just $6bn worth in 2004 to reach a peak of nearly $111bn in 2012, according to IFIS figures. It fell last year to $86bn, as a result of the country’s general election and a prolonged emerging market sell-off, but has reached $26bn already in 2014.
The government has set a target for Islamic banking assets to reach 40% of the total industry by 2020 — almost double their current level.
“It might seem ambitious to some quarters but we came from a single digit market share to around 22% in around 10 years,” says Hamid. “So I don’t think it will prove that difficult to double that within the next six years.”
Malaysia has become the driving force of sukuk innovation and regulation in Asia. But it has also exerted a growing influence on the Middle East and non-traditional sukuk markets such as Turkey and the United Kingdom.
A REGULATORY SPUR TO GROWTH
Global regulatory requirements such as Basel III and bank liquidity have seen Malaysia recently open up two areas of innovative product development.
“Given the gradual de-recognition of Basel II capital instruments starting 2013, several major Islamic banks in the country are in the midst of establishing Basel III sukuk programmes this year,” says Wong Yin Ching, RAM Ratings’ co-head of financial institution ratings. “The combined programme sizes of these proposed sukuk facilities are estimated to be close to M$20bn, although issuances will be phased out.”
Public Islamic Bank is the latest bank to join the drive, setting up a M$5bn ($1.53bn) sukuk programme in April. Subordinated sukuk of this type are treated as tier two regulatory capital. AmIslamic and Maybank Islamic have already issued and RHB Islamic is lining up.
Unlike the Gulf, Malaysian Basel III paper must pass an extra structuring hurdle under Bank Negara Malaysia’s Capital Adequacy Framework of 2012.
“In Malaysia, Basel III-compliant sukuk, similar to conventional Basel III-compliant capital instruments, must explicitly feature loss-absorption terms which allow the instrument to be written off or converted into ordinary shares following a non-viability event,” says Yin Ching.
The Kuala Lumpur-based International Islamic Liquidity Management Company (IILM) made a big breakthrough for short term liquidity in August when it began its long awaited CP-style sukuk programme. It has so far issued five tranches of three month paper.
“The lack of local and foreign currency Islamic paper has been a key constraint for Islamic banks in Asia, as elsewhere,” says Hee Ng. “This makes it, in general, harder for Islamic banks to comply with liquidity regulations than it is for conventional counterparts. But short term sukuk initiatives such as the IILM, which has Asian countries involved, are seeking to address that lack of instruments.”
IILM’s paper is rated A1 by Standard & Poor’s and is backed by the central banks of Indonesia, Kuwait, Luxembourg, Malaysia, Mauritius, Nigeria, Qatar, Turkey, the United Arab Emirates, as well as the Islamic Development Bank.
HONG KONG AND SINGAPORE JUMP ONBOARD
Despite its deep local market, Malaysia is increasingly looking further afield. Hong Kong and Singapore have in turn taken a keener interest in sukuk, both to boost co-operation with KL and to help them compete with other global financial centres.
“Singapore and Hong Kong are looking to capitalise on growing demand by making a bigger push to set themselves up as regional hubs for Islamic finance, particularly with Hong Kong looking to issue a debut government sukuk,” says Hee Ng. “They have put in place infrastructure and this should encourage borrowers from outside the territory to issue sukuk there.”
Hong Kong’s push to issue a debut deal of up to $1bn later this year could establish its Islamic financial centre credentials next to other non-traditional locations such as Luxembourg and the United Kingdom.
The move would also boost cross-border deals between Hong Kong and Malaysia, which began to take off in 2012 but stalled last year.
“Hong Kong’s commitment towards Islamic finance and particularly the development of the sukuk market will help open up mainland China, where there are more Muslims than Malaysia,” says Hamid. “Some of the potential areas of growth there include private banks, private equity and asset management. The legal system has been a limiting factor to date but we have already seen changes happen ahead of the Hong Kong sukuk legislation in that regard.”
PROMISING INDONESIA
Indonesia is widely seen as the most promising area for growth in the Asian Islamic finance market. Its 250m population is 85% Muslim and the country needs to broaden its funding for infrastructure projects.
But so far the population is largely unbanked and the government has issued nearly all of the country’s sukuk, with only $703m from corporate borrowers.
“Indonesia offers an infinite level of potential, particularly on the retail side,” says Hamid. “They have the population, seven to eight times bigger than Malaysia — and predominantly Muslims — so Islamic retail offerings can only grow.”
Last year, Indonesia sold $4.71bn worth of sukuk, according to IFIS — including a $1.5bn dollar deal. It has already sold $1.98bn of sukuk so far this year, having issued a record Rp19.3tr ($1.7bn) of retail sukuk at the start of March.
MISSED OPPORTUNITIES
The story elsewhere in Asia is of even greater unfilled potential. Pakistan has not issued an international sukuk since its $600m five year deal in 2005. It recently re-established its international curve with five and 10 year conventional bonds.
Only $8bn of sukuk has come from the country, although the State Bank of Pakistan recently increased its push for banks to become Shariah compliant.
Meanwhile, India has flirted with Islamic finance for years with very little headway. Bankers say both countries have huge potential, given their large Muslim populations.
“We see throughout Asia that we need to create more awareness in Islamic finance,” says Hamid. “Islamic banking is still in its early days and the market has a lot of room to grow as people begin to champion the sector and develop relationships between different centres.”
Central Asia also has unrealised potential, given the natural fit of its core industries and its large Muslim population. But conventional bond issuance is low there as well.
“If you want to do sukuk in Central Asia, work needs to be done to further develop the financial system,” says Hee Ng.
The Development Bank of Kazakhstan issued a small M$240m sukuk into Malaysia in 2012, but nothing has come of the country’s planned $500m breakthrough.
ADB TO PICK UP THE GAUNTLET?
The Asian Development Bank itself has also long examined the prospect of issuing sukuk. It is widely tipped to make its entrance soon given the benefits this could bring to the region, but ADB says it is not there yet.
“ADB is at an early stage in the consultative process,” says Ashraf Mohammed, the development bank’s assistant general counsel. “No date has been scheduled for any relevant approvals.
“We do see Islamic finance as a key way of reaching communities who may be unable to access conventional sources of finance and have provided Shariah-compliant financing for projects as well as technical assistance to support the sector’s development. Sukuk are becoming a key part of the financial toolbox so we are keen to explore ways to make that work.”
Bankers point to the impact of the Islamic Development Bank (IsDB), which has issued $8.4bn of sukuk to date and financed over $10.4bn of projects in its member states. IsDB has steadily increased the size of its international dollar offerings and priced the last $1.5bn sukuk inside ADB’s conventional bonds — undermining any suggestion that ADB could not achieve tight pricing through the Islamic asset class.
(Emerging Markets / 02 May 2014)
---Alfalah Consulting - Kuala Lumpur: www.alfalahconsulting.com
Islamic Investment Malaysia: www.islamic-invest-malaysia.com
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