Islamic finance gained an extra shine late last year after the World Bank recognised the strategic importance of the funding avenue. The multilateral signed a memorandum of understanding with the Islamic Development Bank on October 13, 2012, “to lend support to global, regional and country efforts in the development of Islamic finance”.
Malaysia, which boasts the world's largest sukuk, or Islamic debt market, particularly stands to benefit from this increasing international recognition.
The country might not appear to be Asia's most logical hub for Islamic finance but its government has been determined for several years to demonstrate that it can mix middle income market sophistication with its religion to offer the most developed hub for sukuk.
At the behest of the regulators Malaysia’s sukuk market has quickly grown, particularly of late. Outstanding volumes increased by 22.6% to MYR1.4 trillion (US$440 billion) in 2012, 69.2% of the world's total volume. The country was responsible for 76.9% of global sukuk issuance last year, according to the Malaysia International Islamic Financial Centre (MIFC).
It's an impressive level of dominat ion for a relatively small country of just 30 million people, only 60% of whom are Muslim.
“Malaysia is really making the effort to try to push the Islamic agenda,” says Teik Leng Yeoh, head of capital markets for Malaysia at Standard Chartered (StanChart). “A lot of it is really down to investor demand. Malaysia-based sukuk funds that we speak with today feel that there are not enough issues in the market.”
This is poised to change. Sukuk could well become a key pillar of infrastructure funding for the Asia region in the coming years. The biggest challenge for Malaysia will be to ensure that its market can keep on developing and offering more sophisticated products. A vital part of that goal will be to expand the market's appeal to new international issuers and investors alike.
Raising volumes
Sukuks are specifically designed to act like bonds, but work in a manner that is compliant with the restrictions of shariah, or Islamic law.
Effectively they are investment certificates that do not offer direct interest or monetary speculation. Instead they pay a profit rate based upon an underlying asset, which is allowed under Islamic law.
There are numerous reasons why Malaysia has been able to carve out a niche in this market. It enjoys a Muslim heritage, western-based legal system but thorough understanding of shariah, it possesses a forward-looking nature, and combines strong links with Gulf states and global financial hubs. This combination of assets makes it a natural candidate to bridge the worlds of religion and capitalism.
Bank Negara Malaysia (BNM) is also highly supportive. On June 26 Zeti Akhtar Aziz, the central bank governor and chairman of the MIFC executive committee, reiterated to Malaysian press that the country’s goal as an Islamic financial market place is to be an open marketplace that is linked to a network of financial hubs.
It has big plans. In 2011, Malaysia's Securities Commission launched the Capital Market Masterplan 2 (CMP2) for the 10-year period to 2020 which includes, among others, strategies to widen the international base of Malaysia’s Islamic capital market. Under this programme, the size of Malaysia's market is projected to grow at an annualised rate of 10.6% per annum to MYR2.9 trillion in 2020.
Key to this will be increased foreign participation. Foreign issuers and investors alike have been increasing their activity in sukuk, which is a positive sign. Interaction between Middle Eastern institutions and Malaysia's market is growing in particular.
“Malaysia is the window for the Islamic market in Asia,” says Rajiv Vishwanathan, associate director for corporate ratings, Asia Pacific at Standard & Poor’s. “The growth in trading relationships between GCC [Gulf Cooperation Council] and Asia is going to drive some of the cross-border issuance.”
About 50% of Asia trade is done with Gulf Cooperation Council (GCC) countries, he adds.
GCC players to have accessed the Malaysian sukuk market include National Bank of Abu Dhabi, which tapped the Malaysian market with a 15-year MYR500 million Islamic bond in November – its third issue in that currency, and also Bahraini sovereign wealth fund Mumtalakat issued a five-year MYR300 million note in September.
Infrastructure appetite
Non-Gulf foreign corporates are also increasingly interested in using the market as a funding source, including Hong Kong-headquartered Noble Group, a supply chain manager of natural resources. The company completed the issuance of its inaugural sukuk in October by issuing a MYR300 million-worth of shariah-compliant notes under the first series of a 20-year Islamic securities programme for the equivalent of MYR3 billion.
“For international issuers, the Malaysian ringgit market offers diversification away from traditional funding sources,” says Yeoh. “The fact that savvy issuers like Noble and Mumtalakat have printed more than one ringgit sukuk trade is a testament that the market has come a long way.”
Another increasingly likely pipeline of offshore deal flow is likely to be from infrastructure companies or projects.
Asia has very large infrastructure needs. The region is estimated to require about US$8 trillion of infrastructure projects between now and 2020, according to experts at a recent seminar entitled ‘Strategies for the development of Islamic capital markets’ organised by the Islamic Financial Services Board (IFSB) in Hong Kong on June 27.
Infrastructure is very complimentary to Islamic finance, where shariah bans the payment of interest on money but allows for returns on hard assets, note experts. Conventional infrastructure transactions like the ones featured in Islamic finance usually feature long-term stable cash flows derived from a designated source or assets. These cash flows are the basis of payments to investors.
The ability of Islamic bonds to help meet such infrastructure funding needs should act as a boon to Malaysia’s market, and mean that it continues to maintain a 70% market share of global sukuk issuance this year.
“2012 was a great year and we continue to expect another strong showing in 2013,” says Badlisyah Abdul Ghani, executive director and chief executive officer, CIMB Islamic Bank to Asiamoney. “Judging from what we have gathered so far, we expect to see a pipeline of deals from companies in the infrastructure, telecommunications, oil and gas and construction sectors, amongst others.”
The way forward
Yet for all these positive developments there are still areas in which Malaysia can work to further encourage sukuk issuance.
The next step of the country's regulators should be to encourage more market standardisation among the various Islamic finance hubs around the world, note experts at the recently-held Hong Kong-based IFSB event.
Some Gulf-based shariah scholars have objected to certain structures used in Asia, a region which has proven to be more flexible in its transactions.
“There are vast differences nationally and there needs to be market-led convergence. It’s the investor base that determines the structure that is used,” said Fareem Ahmed, senior technical adviser at the Islamic International Rating Agency, Bahrain at the event. “The Malaysia-style structure is not acceptable in Saudi Arabia, for example, and as a result, it is not practical to believe in one universal interpretation of shariah. National convergence is more difficult to expect.”
This, however, has now increasingly become the exception rather than the norm as Malaysia continues to tweak its Islamic bond structures to meet Middle East standards.
One noteworthy feature of the sovereign’s US$42 billion global sukuk transaction was how it narrowed the gap between its own booming Islamic bond market and the more conservative Middle East. To enhance its appeal to the region’s investors, it used the wakalah format, which is popular in that region.
Under this structure, 52% of the proceeds are invested in shariah-compliant shares and leasable assets, while the balance is used for entering into a commodity murabahah arrangement with the government.
The commodity murabahah financing is defined as an exchange contract trade between a seller and buyer, where the subject matter are base metals listed on the major commodity exchanges. It is structured in such a way that it leads to the subject matter being exchanged on the spot; in other words, there must not be any involvement of forward contract, where the subject matter is delivered and the price that is to be settled, is to be determined at the deferred date in future.
Gaining a global presence
It's also important for Malaysia and other centres to introduce more cross-border deals if the appeal of the market is to gain more international traction.
Investors interested in buying Islamic instruments should learn to invest in more cross-border deals instead of investing only in their respective jurisdiction and local currency. For example, a large portion of Islamic bond investors in Malaysia are domestically based Islamic fund houses or insurers.
Malaysia’s takaful firms – Islamic insurers – are already major investors in domestically issued Islamic bonds, holding over 60% of their MYR19 billion of assets in domestic private and government securities as of December 2012, according to central bank data.
“The local market that buys into the Malaysian ringgit deals, doesn’t have the mandate to buy US dollar Islamic deals, for example,” says a Singapore-based debt capital markets (DCM) banker. “Funds need to actively invest outside their home market and in the US dollar sukuk space to be able to then see a wider participation and wider pool on pricing.”
Noble Group’s sukuk issuance in January is a good example of a deal that should have been a natural candidate to attract cross-border interest. However, the bond was executed domestically in Malaysia in ringgit due to the reluctance of investors to look outside their own borders.
“The deal had a large participation from Malaysian-based investors,” says a Singapore-based hybrid bond dealer with knowledge of the deal.
Despite this, Malaysia is promoting overseas investment by its takaful firms as it seeks to internationalise its Islamic finance industry. To encourage cross-border Islamic business, the government said in March that these Islamic insurers would be allowed to invest abroad without limit, lifting a requirement for them to hold at least 80% of assets locally.
“Many of the more traditional Islamic funds, whether it’s GCC, Malaysia, Indonesia, are very much investing in their own territory and their own domestic currencies. That’s why you don’t see that cross-border flow as much as you like,” a Malaysian-based DCM head agrees. “Malaysia’s making an effort to encourage this and I think other countries should do it too.”
While there is a pressing need for the cross-border standardisation of these instruments, Malaysia has started to see specks of interest from Middle Eastern issuers. Al Bayan Group, a private holding company, became the first issuer from conservative Saudi Arabia to tap its domestic market, with a small MYR200 million private placement in June.
“The Malaysian sukuk market offers deep liquidity coming from mainly domestic accounts. Many of those have continuous appetite for good Malaysian papers and have little exposure in global fixed income markets,” says CIMB’s Ghani. “So long as the credit makes sense, investors would come in.”
More such deals should gradually extend the appeal of non-local sukuks with Malaysian investors, as they become more comfortable with such exposures. Increasing the regularity and appeal of such deals will take time, but it's a necessary step if the sukuk market is to gain a broader-based appeal.
Malaysia looks set to remain the heart of Islamic debt funding, but it can't hurt for the nation to ensure it has as broad a base of issuers and investors as possible.
