GULF STATES/MALAYSIA: Innovation spurs Islamic finance

Analysis

Banks in Malaysia and the Gulf share a common interest in Islamic finance (see GULF STATES/MALAYSIA: Islamic finance links grow - December 22, 2004). This is starting to produce synergies that are profitable for Malaysian financial institutions and potentially helpful for the Muslim world more generally, including its poorer members. At the Putrajaya meeting, Malaysia proposed that the IDB establish a fund to finance infrastructure development in poorer member states.

Infrastructure bond fund . This would be financed through the issue of Islamic asset-backed securities, with the more prosperous Muslim countries such as Malaysia and the Gulf states providing assets. Such backing would improve the rating of the securities and lower the financing costs. The initiative is not entirely altruistic: Malaysian banks stand to gain from the arrangement and management fees, while the country's leading construction companies should be well placed to win some of the contracts for the infrastructure work.

Malaysian experience. CIMB Islamic, the Islamic financing subsidiary of the largest investment bank in South-east Asia, has been involved in arranging the second global 'sukuk' (Islamic tradable securities with a fixed period to maturity) issued by the IDB worth 500 million dollars, the other managers being Dubai Islamic Bank, HSBC Amanah and Deutsche Bank. Islamic banks from the Gulf are taking up much of the issue, as well as institutions from oil-rich Brunei, including the Employees Trust Fund and the Islamic Bank of Brunei.

Malaysia has over a decade of experience of funding infrastructure projects through Islamic securities issues. Four offerings are currently being promoted for PLUS Expressway, the operator of Malaysia's major toll roads, including the north-south highway linking Thailand with Singapore. The roads can be used for the asset backing, with the tolls providing the revenue stream.

The 11-14 year maturity periods are much longer than for most Islamic securities to date, which typically mature after five years. However, the phased maturity of the four issues means the highway operator has flexibility over refinancing should it be necessary, rather than having to repay all the security holders on the same date. It is this type of long term planning that has proved so helpful in Malaysia's case, and which the Gulf states can usefully emulate as good financial practice.

Sukuk take off. Until 2000, the only sukuk were corporate issues denominated in ringgit and traded through the Kuala Lumpur stock exchange:

• Total issuance increased from 336 million dollars in 2000 to 630 million in 2001, including the first issue in the Gulf, on behalf of the government of Bahrain, worth 100 million.
• The value of issues worldwide rose to 700 million in 2002, but it was in 2003 that issues dramatically expanded with sovereign sukuk worth 1.2 billion dollars issued and corporate issues worth 4.6 billion.
• The momentum continued in 2004 with total issues worth almost 7 billion, and in January-June 2005 the value of issues has already reached over 5.2 billion, which may result in total issues approaching 10 billion by the end of the year.

Gulf boom. Although Malaysia continues to account for most of the issues of corporate sukuk, an increasing number of countries are involved, including last year Germany, through an issue by the state of Saxony-Anhalt of the first and only euro-denominated sukuk. However, the highest value sukuk are being issued in the Gulf. The record to date is the 1 billion dollars raised last year by the Dubai Department of Civil Aviation for its second airport terminal, a dedicated facility for Emirates Airlines capable of handing the Airbus A380 aircraft of which the airline will take delivery from the end of 2006.

Emirates Airlines, which has previously used Islamic leasing contracts to finance some of its aircraft, issued its first-ever sukuk on June 10. The initial offer was for 550 million dollars to fund a new engineering centre in Dubai. The offer was oversubscribed, with 824 million raised. The additional funding is being used to refinance the building to house the headquarters for the Emirates Group, as the sukuk pays 0.75% over the six-month London Inter-Bank Offer Rate (LIBOR), which is cheaper than its present conventional financing.

Sukuk innovation. At present most sukuk are either based on Islamic leasing (ijara) contracts, with rent adjustments allowing for a variable return similar to a floating rate note, or mark-up trading contracts (murabahah), where the return is fixed, similar to a bond. They are legitimate under Islamic sharia law because there is a real asset backing the contracts; hence when the securities are traded, title to a real asset is involved, rather than simply the trading of paper. However, many sharia scholars have been uneasy that returns on the ijara sukuk are typically benchmarked to LIBOR, an interest rate indicator.

In Malaysia, there have been experiments with new sukuk structures, notably those based on musharakah (partnership) financing, with profit shares determining the return. CIMB Islamic has taken a lead with an issue for Musharakah One Capital Berhad, a venture capital fund, worth 658 million dollars earlier this year.

This month, Bahrain-based Arab Banking Corporation's Islamic subsidiary arranged the first ever musharakah-based sukuk in the Gulf on behalf of Investment Dar of Kuwait. The 50 million dollars raised will also be used for venture capital finance. Although at present the venture capital industry is much less developed in the Gulf than in Malaysia, it has significant potential, especially in the United Arab Emirates and Saudi Arabia.

Outlook. Kuwait's leading Islamic Bank, the Kuwait Finance House, is opening a branch in Kuala Lumpur, and the Al-Rajhi Banking and Investment Corporation, the largest Islamic bank in Saudi Arabia, is planning to follow. These will provide a window to the sharia-compliant investment opportunities in South-east Asia for liquid funds from the Gulf, which have been much boosted by high oil prices (see GULF STATES/ASIA: Growing ties point to secular shift - June 14, 2005). MayBank, the largest bank in Malaysia, already has a branch in Bahrain.

This Islamic connectivity through financing can also spin over to neighbouring countries:

• Indonesia has followed Malaysia's example, with four corporate leasing sukuk offered in the last year, including an issue by PT Indonesian Satellite Corporation, a major local telecommunications company.
• The A'ayan Leasing and Investment Company of Kuwait is investing an initial 12 million dollars in a new Islamic bank in neighbouring Iraq.