THE NEXT FINANCIAL OASIS?
Islamic finance could be a promising well of capital for Asia’s CFOs. But many questions remain unanswered.
By Don Durfee

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 chart).

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 al-ijara 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 no-tax 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.