Indonesia has been taking crucial steps towards establishing itself in the Islamic finance space and while it may have a long way to go before it can match neighbouring Malaysia in this area, this progress bodes well for Islamic finance in the region as a whole. By Nachum Kaplan.
Indonesia has gone down two routes towards establishing itself in the Islamic finance sector: it has begun putting in place the regulatory framework for Islamic capital markets; and the sovereign has begun issuing sukuk to increase its Islamic credentials and its profile among Islamic investors.
As the world's largest Islamic country, Indonesia naturally has high ambitions in the Islamic space but until very recently almost all of the government's efforts have been about developing its conventional finance sector. This can be seen from the fact that Islamic banks in Indonesia account for just over 2% of the industry with a meagre US$4.5bn in assets.
The focus is changing now that Islamic finance has become more mainstream, regionally and globally, and because the expanding role of Islam in Indonesian political discourse is providing an impetus for the financial sector to follow. The government has begun putting in place the legal framework for more Islamic finance activities. This is a slow process, however, partly because of the technical nature of the matter but also because Indonesia's legislators are notorious under-achievers.
In June 2008, the country took its first major step with the passing of the Sukuk Law. This law established a body called the DSN, which is charged with approving all Sharia products and services issued the country. It is modelled on Malaysia's Sharia Advisory Council. The DSN will not rule only on the acceptance of sukuk structures but on any and all Islamic instruments so its creation is an important step for the development of Islamic finance in Indonesia as a whole.
The passing of the Sukuk Law paved the way for the republic's first sukuk issue last year and has spawned an impressive spate of Islamic issuance in both rupiah and dollar markets (see below) this year.
Having built the right broad framework for sukuk issuance, the government is now working on a regulatory framework that would allow for the issuance of project finance-structured Islamic bonds. These new regulations will not be ready until 2010 but the search is already on for projects that would be suitable for the country's first project finance-like sukuk.
Indonesia has huge project finance requirements and its progress in building and upgrading its creaking infrastructure has been painfully slow. The government puts its required infrastructure spending for the next five years at about US$72bn and is keen to draw on Islamic liquidity to help fund this. This sounds like an exciting prospect for Islamic finance in the country, but bankers warn that liquidity is not the main obstacle in getting projects off the ground.
"Just looking at the numbers, it seems that project finance and Islamic finance could make for a perfect marriage in Indonesia, but the numbers really aren't the issue," said a foreign Jakarta-based banker. "Infrastructure development in Indonesia is slow for political and regulatory reasons. Sure, they need to be able to raise the money and all new sources of liquidity would be welcome, but if they don't sort the bigger issues out, it's unrealistic to think infrastructure is going to be a boon for Islamic finance in Indonesia."
Beyond the project finance space, more legislation is needed along with revisions to many other lower-level regulations before the country can claim to have a solid framework from which Islamic finance can grow.
Statutory provisions to ensure tax neutrality for sukuk versus conventional bond issues are required so issuers do not receive less favourable tax treatment if they issue sukuk rather than conventional bonds. This is necessary to put Islamic issuance on an equal footing with conventional bond issuance and it is one reason why almost all Islamic issuance from Indonesia has been state-linked rather than corporate.
Legislators are not the only important players in getting Indonesian Islamic finance off the ground. Other institutions with regulatory responsibilities will also need to get in on the act.
This is starting to happen. Bank Indonesia, the central bank, is revising and reworking a spate of regulations that will allow the country's Islamic banks to trade their sukuk in the secondary market rather than hold them until maturity. This would allow holders of Indonesian Islamic instruments to engage in more sophisticated portfolio management.
Likewise, the country's Capital Market Supervisory Agency (Bapepam) has made establishing Sharia capital markets and products one of its priorities over the next five years and it is responsible for many of the regulations than govern day-to-day capital market activities.
Indonesia faces other challenges beyond regulation in getting Islamic finance off the ground and one of its main hurdles will be finding enough qualified people. Islamic finance has grown so quickly both globally and regionally that there is a global talent shortage. Theoretically, Indonesia could poach talent from Malaysia, with which it even shares a common language, but Malaysia is feeling the shortage of talent too.
This is one area where the global financial crisis might be boon for Islamic finance. Most Islamic bankers, even the very experienced ones, began their careers in conventional finance and so many bankers have lost their jobs that there should be plenty of talent to choose from, even if some further training is required. The talent shortage looms as a serious constraint on Islamic finance's development and that is as true in Indonesia as it is anywhere else.
Sovereign sukuk
The other plank in Indonesia's drive towards becoming a player in Islamic finance is to establish its issuance credentials. The country has been one of the world's star performers in withstanding the global financial crisis. Its economic growth rate is well above 4% and its banks are among the best capitalised in the world. This has given the sovereign relatively easy access to global financial markets, which the republic has tapped using conventional and Islamic issues. The government needs to keep issuing because, despite its macroeconomic success, it is running a budget deficit of 2.5% of GDP.
At the start of the year Indonesia set itself a 2009 sukuk issuance target of Rp23trn and three-quarters of the way through the year is well on target to meeting it, having issued Rp19trn in the first eight months of the year. The balance of Rp4trn is expected to be sold through a series of Islamic bond auctions beginning this month. The target might well have been met sooner but Indonesian financial markets all but close down during the Muslim fasting month of Ramadan, which ended in mid-September.
The government knocked off half the target with its first two Islamic issues this year. The first, in April, was a Rp5.556trn retail sale of three-year notes and it was hugely oversubscribed. The second was a US$650m global sukuk sale of five-year notes in April, which was also enormously oversubscribed.
Despite the success of these deals, the government has since eschewed further retail and global sukuk and is now using private placements and Islamic bond auctions instead. The government has said that it was varying issuing structures and mechanisms so as to reach as wide an investor base as possible. This serves several functions: it maximises liquidity, diversifies funding sources and helps educate investors.
Private placements were next off the block and in May the Indonesian Ministry of Finance announced plans to sell Rp9trn of Islamic bonds through private placements to the Ministry of Religious Affairs, and promptly placed the first Rp1.5trn in the first week of March.
The non-tradable notes paid an 8.52% dividend and were structured using the ijara al khadamat format. The underlying assets that the notes were secured against were services used in the operation of Haj pilgrimages, such as transportation, catering and hotel services.
This was important because, while there is considerable focus on the mechanisms that Islamic instruments use to avoid using interest payments, this is not the only thing that makes a financial instrument Sharia-compliant. The assets that the issued are secured against and the purpose the proceeds will be used for also need to conform to Islamic values. The risk of Sharia auditing committees shooting down the legitimacy of many deals on these grounds in the future is very real.
The Indonesian government is now preparing to try its hand at Islamic bond auctions. The first was expected in early October with a second one following two weeks later, assuming the first one was well received. Further auctions in November and December may also be held if the required Rp4trn has not been raised by then.
In conclusion, Indonesia has taken some important steps towards becoming a player in Islamic finance but those steps are baby steps and more work needs to be done. Indonesia is infamously slow at getting any sorts of legislation in place quickly, let alone for a topic as technical as Islamic finance. However, if the will is there, the country should be able to make progress quite quickly because it has, next door in Malaysia, a strong and detailed blueprint for developing Islamic finance from which it could learn.