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Regulatory flaws impair Indonesian sukuk development

28 Feb 2013

Indonesia’s current legal infrastructure is a hindrance to the growth of its domestic Islamic bond market, dampening the nation’s hopes of becoming the next sukuk destination for corporate debt issuers.

The world’s most populous Muslim nation, Indonesia, hopes to establish itself as the next best destination for sukuk issuers, but the nation’s archaic and fragmented Dutch law system is proving to be a drawback.

Indonesia is perfectly set up the emulate Malaysia’s success in using Islamic finance for funding purposes. But while in the latter country, the participation of corporations early on spurred sukuk issuance, in the former, only the government has adopted Islamic funding.

“The number of Indonesian sukuk issuers is very few and the ones that have been doing it are essentially the government,” said a Malaysian-based head of debt capital (DCM) markets to Asiamoney PLUS in a telephone interview on February 26. “For the government, there’s nothing as tax and it’s not as tax efficient for corporates to issue Islamic bonds in Indonesia.”

Malaysia, home to the world’s largest sukuk market, has been at the forefront of Islamic bond issuance in both the corporate and sovereign space.

However, Indonesia managed to play catch up somewhat last year, issuing a total of US$1 billion in global sovereign Islamic bonds, 18% more than Malaysia’s US$817 million, according to Dealogic data. In contrast, Malaysia was leading the world in terms of sovereign issuance in 2011, recording a total of nearly US$3 billion in global sukuk issuance, three times higher than Indonesia’s.

In the corporate space, Indonesian companies came fifth in terms of geographic ranking after corporates from Malaysia, Saudi Arabia, Singapore and United Arab Emirates and accounts for only 2.4% of Malaysia’s total volume of US$15.2 billion in 2012, notes the data provider. The Indonesian sukuk market failed to secure a corporate deal in 2011.

“The tax laws and the legal infrastructure make it not very conducive to put out a sukuk [in Indonesia]. In Indonesia, the legal framework is quite fragmented where within each sub-district, there are different laws,” said the DCM head. “To combine everything together is not the easiest things to do because in order to rationalise the laws, you need to go sub-district to district to state – which is tedious – and they don’t follow the British system.”

As it stands, Indonesia’s civil law code – which is based on Dutch law – does not recognise the separation of legal and beneficial titles, note experts. Having beneficial ownership in an asset means that the investor can take advantage of the economic benefits that the asset is able to offer. For example, a sukuk holder can receive rent from a commercial property leased to another party without holding its legal title.

If beneficial ownership is recognised like in Malaysia, it makes it easier and cheaper to complete sukuk transactions, which should in turn attract more corporate deals, highlight market participants.

Another key hindrance to Indonesia’s development is a lack of tax incentives.

“Malaysia has that legal concept of a legal title and beneficiary interest. For example, [in Islamic finance] you transfer the legal title across when you sell the product but you still have the beneficiary interest in it, so it’s still yours. Technically, it’s not a true sale, so it’s not taxable as you haven’t actually sold it,” said a Singapore-based fixed income strategist to Asiamoney PLUS. “But in Indonesia, if you don’t have this concept then it is very difficult. When you sell it, it means that you have sold it. So you have this nonsense about capital gains and you are going to be taxed straight away.”

Malaysia has been seen as far more attractive when compared to Indonesia for issuers from a pricing perspective as well.

Dealers have been able to price a five-year corporate sukuk between 10 basis points (bp) to 20bp higher than a Malaysia government security (MGS) with a similar tenor. Currently, a five-year MGS is hovering around the 3.2% level. In Indonesia, bond dealers would price a five-year corporate sukuk at 50bp-60bp higher than its local government debt, which is currently around 4.78%.

Despite all these ongoing concerns, the nation is making an effort – albeit a slow one, note experts. In June 2008, the country took its first major step with the passing in the sukuk law.

Additionally, Indonesia had been stepping up its sovereign-paper programme, with the introduction of new sukuk laws and more favourable legislation to encourage issuance, which should help stimulate market interest for the Islamic productin the coming years.

“The recent sovereign issuances should help attract greater contribution from the country's private institutions, particularly the corporate sector, but this needs additional supportive regulation,” said Rajiv Vishwanathan, associate director for corporate and infrastructure ratings at Standard & Poor’s (S&P) to Asiamoney PLUS in an email reply to questions. “If a wide range of industries begins to issue sukuk, it could spur the growth of Islamic banks, takafuls and Islamic funds.”

Takaful-branded insurance is based on shariah, Islamic religious law and explains how it is the responsibility of individuals to cooperate and protect each other.

28 Feb 2013