Capital Markets

The Next Financial Oasis?

Islamic finance could be a promising well of capital, but many questions remain unanswered.
Don DurfeeFebruary 21, 2008

One year ago, Aeon Credit Service received an infusion of capital
from an unfamiliar source. Through its
Malaysian subsidiary, the Japanese financial
services company raised money from devout
Muslims in Malaysia and the Middle East
though an Islamic bond, also known as a sukuk.
As capital markets transactions go, this one was
small, worth only 400 million ringgit (US$122
million). Most of that money will find its way
into Islamic loans that Aeon’s local unit makes
to small businesses and entrepreneurs, says
Krishnappan, executive director in charge of
finance for the Malaysian operation.

But the deal was symbolic — Aeon is the
first Asian company outside of the traditionally Muslim
nations to use sukuk. And it won’t be the last,
asserts Badlisyah Abdul Ghani, head of Islamic banking
for Kuala Lumpur–based CIMB, the bank that
arranged the deal. “We are receiving quite a lot of
interest from Japan and Korea, as well as Thailand
and the Philippines,” he says. “It’s not just investigating
and talking. Real mandates will be coming in this
year from institutions outside of Southeast Asia.”

Islamic finance — the practice of raising capital in
ways acceptable under sharia, or Islamic law — is on
the rise. The field spans a broad range of products,
from consumer and corporate debt to equity. sukuk
are receiving most of the attention these days. In
2007, companies and sovereigns used them to raise
US$52 billion, compared with almost nothing at the
start of this decade, according to the Islamic Finance
Information Service (see “From Modest Beginnings” at the end of this

There’s now an estimated US$1 trillion in Islamic
capital available for investment. As that pile of
cash grows — swollen by US$100-a-barrel oil — the
holders of that money are increasingly looking for
new places to invest. China and India are high on
their list, say bankers.

But don’t expect a rush to sukuk just yet. There are
many unanswered questions and, perhaps, liabilities
that must be understood before great numbers of
CFOs will embrace them. Islamic bonds are relatively new, and there have
been few defaults
to date. There are strong disagreements
among Islamic scholars who rule on
whether financial structures pass muster,
creating the possibility that a financing
deal approved today could be unacceptable
tomorrow. And in many countries the
legal and tax implications of Islamic
finance haven’t been fully worked out,
exposing issuers and investors to risks they
don’t confront with conventional bonds.

No Interest

Islamic finance isn’t new, but it’s taken off
only recently, propelled by vast oil wealth
and a rising sense of Islamic identity
among Middle Eastern investors. It’s different
from conventional finance in two
key ways. First, a range of industries are
off limits to investors, including those
involving alcohol, pork, gambling,
pornography, and weapons. Further,
sharia prohibits usury, so the paying or
receiving of interest is forbidden.

Lenders, of course, require some
return on their money. But while Islamic
law prohibits interest, it does permit
investors to earn rent or receive a share of
an income stream. To make sukuk possible,
lawyers and bankers have built elaborate
structures to allow investors to get
paid without charging interest. Many of
these look much like securitization.

One common structure is the sukuk al-ijara, or lease. The company
hoping to
raise money will create a special purpose
vehicle (SPV) and sell an asset — ideally
something tangible like a road or a building,
but a pool of intangible assets is also
possible — to that SPV. The SPV sells ownership
rights in the asset to outside
investors and transfers the money back to
the company as payment for the asset. In
return, the company makes regular lease
payments for an agreed period. When
that period is over, the issuer buys back
the asset, effectively redeeming the bond.

Another variant is the musharaka, or
joint venture arrangement. Under this
arrangement, borrower and lender form
a business together, with the issuer holding
10 percent of the equity, say, and the
investor holding 90 percent. The JV buys
an asset from a company looking to raise
money, and the partners receive proportional
revenues from the asset during the
life of the deal. At the end, the issuer buys
out the partner’s stake.

All such structures — and, indeed, any
sukuk — require a stamp of approval from
a sharia board hired by the issuer and
another hired by the investors. The boards
consist of Islamic scholars who rule on
whether or not a particular deal complies
with Islamic law. At heart, says Badlisyah,
the structures that scholars approve of
reflect indebtedness arising from trade
activities, whereas conventional bonds
reflect debt from borrowings. “From an
economic perspective, the return from the
trading activity is the same as the interest
on the money,” he says.

Another way of putting it might be
that sukuk are debt in another guise. That
similarity has drawn criticism from some
Islamic scholars and finance academics.
Mahmoud El-Gamal, chair of Islamic
finance and economics at Rice University
in Texas, has criticized the sale/leaseback
structures such as those used in sukuk alijara
as merely serving to “disguise interest-
bearing debt.”

But mirroring conventional instruments
means that sukuk are easy to price.
Islamic bond contracts typically reference
LIBOR when defining the returns due to
the parties. That makes it possible to
compare sukuk to other sources of financing
and easier to trade (although the secondary
market for sukuk is still underdeveloped).
It also helps draw investors from
the conventional bond market.

The Long and Short

Islamic bonds pose some unique challenges.
To understand the pros and cons
of sukuk, consider the US$850 million
convertible Islamic bond issued last summer
by Khazanah, Malaysia’s state investment
agency. The sukuk are exchangeable
for shares of PLUS Expressways, a
Malaysian toll-road operator. By any
measure, the transaction was a success.
Demand was strong — the issue was 13
times oversubscribed — and the issuance
drew a broad range of investors, half from
the Middle East and the rest from conventional
capital markets. The company
was pleased with the pricing, which
amounted to a 4.58 percent yield to maturity,
90 points below the five-year U.S.
dollar swap rate.

Furthermore, the convertible structure
allowed the state investment agency to
achieve its twin goals of tapping Middle
Eastern liquidity and launching
an orderly selloff of one
of its assets, since bond
holders will only gradually
convert their holdings into
shares of PLUS Expressways.

But the process took
longer than a conventional
bond would have — six-to-eight
weeks compared with
three-to-four weeks. This
was largely because Khazanah
was using a structure
that’s still unfamiliar to
Islamic investors — the only
convertible sukuk floated
before was done by Khazanah
last year. That one,
which won a spate of awards
for its novel structure, took even longer.

“When a product is new you need to
educate the investors to get their buy-in,
and you need to get the approval both of
the issuers’ and the investors’ sharia
boards,” says Mohd Nadziruddin bin
Mohd Basri, Khazanah’s CFO. “It was easier
with the second issuance, but even
then we spent a fair amount of time doing
pre-marketing, creating brochures, and
meeting with Middle Eastern investors to
explain how the structure works.”

Bankers and lawyers agree that complex
sukuk can take longer to complete
that conventional bonds, but argue that
most deals can happen quickly. The legal
costs are steeper, however. “The costs on
the legal side are quite a bit higher,
because the documentation and the
structuring are more complex,” says Alex
Regan, partner with international law
firm Paul, Hastings, Janofsky & Walker in
Hong Kong. “But that’s a small component
if you’re looking to do a large issue
and you get a price benefit from issuing to
Islamic investors in the Middle East.”

In any case, an issuer may be able to
avoid the extra cost altogether. Afaq
Khan, CEO of Standard Chartered’s
Islamic bank in Dubai, says that costs are
declining and that banks will typically
pick up any incremental cost of Islamic
documentation over and above conventional
issuance costs.

Such issues were minor compared to
the main benefit, though, says Nadziruddin:
good pricing by widening the pool of
potential investors. “With sukuk we can
attract both sharia as well as conventional
investors,” says Nadziruddin. “Once you
have a larger order book you can push for
better pricing.”

There’s a bigger worry than timing or
cost, though, and not just for Khazanah:
in November, a Bahrain-based standards-setting
organization for Islamic finance
declared that 85 percent of the sukuk
issued in the Gulf states don’t comply with
sharia. At issue is the repurchase agreement —
the promise that the issuer will
buy back the asset at maturity or in the
event of default — that underlies most
Islamic bonds, including Khazanah’s. The
organization will meet early this year to
discuss the matter.

If it bars the use of repurchase agreements,
it’s not yet clear how that will
affect sukuk already issued — those, after
all, have already been formally sanctioned
by sharia boards. But the debate highlights
another concern with Islamic
finance: financial instruments must be
approved by religious authorities, but
those authorities don’t always agree.

“There’s enormous debate as to what’s
sharia compliant,” says Craig Nethercott,
head of the Islamic finance practice for
law firm White & Case in London. “A
structure that works for one sharia board
may not work for another. But Islamic
finance is going through rapid development
of different products. In a few years,
you’ll see that there are forms that are
more accepted.”

Beyond the Islamic World

For now, however, such uncertainly does
not bode well for the industry’s efforts to
encourage companies from non-Muslim
countries to embrace Islamic finance.

To date, there have been only a handful
of such issues. Aeon Credit’s deal was
one. Others include a Texas energy company
that raised US$166 million in 2006
and a city in the German state of Saxony-
Anhalt, which issued a sukuk in 2004.
Standard Chartered’s Khan cites a number
of possible reasons for the slow
uptake. These include the very cheap capital
that was available in the conventional
markets up until the sub-prime crisis that
began last summer, and the strong growth
among Gulf states, which has given Islamic
investors plenty of local opportunities.

There’s another: regulatory barriers.
sukuk may operate like debt, but tax collectors
often don’t see it that way. In most
Western countries, for example, the back
and forth trading that underpins many
Islamic bond structures generates big tax
bills — selling a piece of property to the
investors who then sell it back might kick
in two instances of capital gains and transfer
taxes, for instance, in the United States.

“It’s much easier to structure sharia-compliant
transactions in low-tax or notax
jurisdictions,” says Nethercott. “When
you try to take products that have been
developed in the Middle East and apply
them to the UK, as we have, you get terribly
hung up on taxes that were not
designed for this kind of financing.”

Many governments — including the
UK — are working to amend their tax laws
to exempt Islamic financing deals from
any tax over and above what an issuer of
conventional debt would pay. Here in
Asia, Singapore and Hong Kong are also
working on similar changes, and Indonesia
expects to produce new laws this year.
Khan serves on the Hong Kong and the
UK committees studying sukuk. “Sometime
this year we’ll see regulation allowing
sukuk to happen in Hong Kong, too,”
he says.

In the meantime, many governments
allow their companies to raise sukuk overseas
and avoid the various taxes that
would make such deals uneconomic at
home. Japan is one, says Badlisyah of
CIMB. “The regulatory framework in
Japan is not yet ready to facilitate Islamic
bonds, however it does not stop Japanese
firms through their overseas operations to
issue sukuk in Malaysia,” he says.

The complexity of many Islamic structures
may also ward off some CFOs.
sukuk may be no more complex than the
average securitization put together on
Wall Street, but they are trickier than regular
bonds. The use of SPVs, for example,
will surely remind some CFOs uncomfortably
of the off-balance sheet entities
that starred in the Enron scandal almost
a decade ago.

The arrangers of sukuk insist that the
structures aren’t hard to grasp. “We’ve
been through discussions with some
Western companies that look somewhat
suspiciously at Islamic financial products,”
says Nethercott. “There is increased complexity
of the financing source, depending
on the structure you need to choose. But
the underlying structures aren’t that different
from conventional structures.”

Badlisyah says that sukuk are easily
explained using charts that illustrate how
they differ from conventional finance.
“Most clients get the right understanding
easily,” he says.

But Ambreesh Srivastava, a senior
director with Fitch Ratings in Singapore,
argues that there are still many uncertainties
with sukuk, particularly those denominated
in local currencies in the smaller
markets such as Indonesia or some Middle
Eastern countries.

For example, what would happen in a
default situation? Consider the musharaka
structure, in which lender and borrower
are technically equity partners in a
business. “If you truly look at it in a profit-
and-loss concept, even though the
issuer has given some indicative return
expectations to investors, if they are not
able to meet those expectations it may not
be legally enforceable,” says Srivastava.
“Investors were expected to share in the
risk of the venture.” To date, there have
been few defaults to generalize from.

Also, while international sukuk are
usually governed by UK or New York law,
it’s unclear what courts have jurisdiction
over some of the locally issued bonds. “If
there’s a dispute, where does it get settled —
in a conventional court or a sharia
court?” asks Srivastava. “Even when we
talk with regulators, there’s not a lot of
clarity on these kinds of issues.”

Such concerns should certainly give
CFOs pause; especially at a time when
complex financial instruments are causing
such turmoil in other parts of the
financial world (Islamic financial institutions
have so far escaped damage from
the sub-prime crisis, since they couldn’t
invest in conventional mortgages in the
first place). Still, sukuk are a tempting
source of capital for CFOs everywhere —
it’s competitively priced money available
from a growing pool of investors companies
wouldn’t otherwise reach. Just be
sure to ask the right questions.

Don Durfee is managing editor of CFO Asia.

The Biggest of 2007
Date Issuer Country Value
in $ mill.
12/10/08 Binariang GSM Sdn Malaysia 6,280 MYR
6/25/08 Cagamas Berhad Malaysia 5,790 MYR
6/25/08 Cagamas Berhad Malaysia 2,890 MYR
2/11/08 Aldar Properties PJSC United Arab Emirates 2,530 USD
8/6/08 Saudi Basic Industries Corp. Saudi Arabia 2,100 SAR
11/20/08 Jebel Ali Free Zone FZE United Arab Emirates 2,042 AED
9/4/08 Bumiputra-Commerce Holdings Berhad Malaysia 1,723 MYR
7/2/08 DP World United Arab Emirates 1,500 USD
7/18/08 Saudi Electricity Co. Saudi Arabia 1,333 SAR
6/7/08 Dubai Intl. Financial Center (DIFC),
Dubai Sukuk Centre Ltd
United Arab Emirates 1,250 USD
Source: Islamic Finance Information Service

Total annual sukuk issues