Malaysia woos sukuk trade

IFR IMF Special Report 2011
11 min read
Kit Yin Boey

Islamic finance gained an additional sheen this year after the World Bank acknowledged the strategic importance of the new funding avenue. Malaysia, as the largest sukuk market in the world stands to benefit.

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Malaysia accounts for about 65% of all sukuk issues, a market which has grown by leaps and bounds in the past decade with an average annual growth of 15%. Yet, despite these statistics the country suffers from an image of being an insular market with issuance mainly confined to local borrowers and investors. This is expected to change as the government is now actively encouraging foreign issuers to consider selling in sukuk format when they tap the ringgit bond market.

A report from the Kuwait Finance House estimated that some US$47bn worth of global and domestic sukuk were issued in the first half of this year, exceeding the whole of last year’s US$45bn, which was itself a record high.

That phenomenal growth is likely to be reflected in Malaysia this year. Thomson Reuters data showed that the total volume of Islamic bonds issued in the country reached US$28bn in the period of January 1 to August 15, almost double the US$15.2bn issued over the corresponding period last year. In stark contrast, Indonesia trailed a distant second, at only US$2.5bn over the same period this year, with Bahrain at US$1bn and Saudi Arabia at a mere US$480m.

It is a step in the right direction but is unlikely to bear fruit as swiftly as it did about four years ago when the government embarked on a series of overseas roadshows to internationalise the country’s reputation as an alternative bond hub. That paid off handsomely when the global financial crisis broke in 2007 and borrowers from South Korea, India and the Gulf region – shut out of the global market – came to the conventional ringgit bond market in droves.

Largely as a result of that, Malaysia’s bond market deepened and broadened and now boasts a well-diversified base. In fact, it has become a viable alternative funding market for overseas borrowers.

Getting foreign borrowers to sell utilising Islamic structures, however, presents more challenges. An unwritten government directive to push all foreign issuers to offer sukuk rather than conventional bonds in the domestic market filtered out last year and was thought to be part of the second stage of the government’s plan to promote the ringgit bond market as the Asian centre for the asset class.

“This is part and parcel of the government’s aim to promote the country’s debt markets as a hub for sukuk issuance,” said a Malaysian banker. “The first step to draw in foreign issuers to sell conventional bonds in ringgit was a success, so it is only natural that the government is now taking that to the next level – to get the foreign borrowers to sell Islamic bonds.”

Nevertheless, the government is also aware that commercial banks will have great difficulty in meeting Sharia compliance, given that interest-bearing loans account for a large portion of their business. Most of the South Korean borrowers that came to Malaysia were financial institutions.

But there are also South Korean corporates keen to tap the sukuk market, using the developed Malaysian bond market to tap the Middle East investor base. One such borrower is GS Caltex, which has been eyeing an Islamic bond since 2009. It was eager to proceed with a sukuk deal despite the lack of tax breaks, but is thought to have held back after the South Korean government indicated it wanted to sell a benchmark sukuk issue should the new laws get passed in parliament.

Egged on by these potential borrowers and the great potential of the Islamic financing markets, the South Korea government has for the past couple of years attempted to introduce tax breaks for sukuk issuance. But the attempts have failed so far, hobbled by strong opposition in that country to Islamic finance, with a powerful lobby of staunch Christian groups resisting the bill.

Gulf optimism

While Islamic financing hopes languish in South Korea, sukuk from the Gulf region have shown far more promise. In late July, Gulf Investment Corp privately placed M$750m (US$252m) of five-year Islamic bonds at a coupon of 4.90% with a yield to maturity of 4.75%. This was its second sukuk, with the first sold just six months earlier in February, but GIC achieved far tighter pricing, shaving 50bp off the February deal. It was its third issue in Malaysia, its M$1bn debut having been a five-year conventional transaction in February 2008.

July’s deal was done just before the global financial markets went into a tailspin in early August, shutting down the G3 markets and cutting off access to the US dollar markets to lower rated and high-yield borrowers.

What it has done is emphasise the urgent need for these borrowers to put in place alternative funding plans, and some of them have already turned to the next best choice – South East Asia’s local currency markets.

GIC is but one of a handful of Gulf borrowers looking at the ringgit market. Among them are Gulf Investment Bank from Bahrain and Abu Dhabi’s Department of Transport, both of which are said to be setting up sukuk programmes that will give them quick access to the ringgit market. Another well-publicised name was the government of Dubai, which was working on establishing a programme in February. However, issuance from that sovereign remains a remote prospect in the near term as investors are still nervous about its financial status.

“The Gulf names have had no problems accessing the US dollar markets since the crisis, but they are smart borrowers. They set up programmes here and they can tap the market whenever a window opens,” said a debt syndicate banker.

“These borrowers play on the ratings arbitrage: they are able to get competitive funding costs here since they can get domestic Triple A ratings against the Single or Double A ratings they have internationally.”

For the Gulf borrowers, ringgit funding may prove attractive for Single or even Double A borrowers finding it tough to access the tight US dollar market as more funds divert to save-haven credits. In the week of August 8, which saw markets sink amid heightened risk aversion, Malaysian bond traders reported a surge in foreign fund inflows in search of safe-haven assets in Asia.

“The first step to draw in foreign issuers to sell conventional bonds in ringgit was a success so it is only natural to take that to the next level – to get the foreign borrowers to sell Islamic bonds”

“It works for borrowers rated A1 to A3 internationally to fund in ringgit,” said the banker. “They would be looking at 150bp–200bp over Libor in the US dollar markets, but it would be cheaper in ringgit, even on a swap basis.”

To bring Malaysia’s sukuk markets to a higher plane, the government is also likely to push for issuance of sukuk in US dollars. It partly achieved this with its own US$2bn dual-tranche Islamic bond, which drew an astounding US$9bn in orders – more a reflection of Malaysia’s rare sovereign credit in the G3 markets than the fact that it was a sukuk transaction.

But it builds on the first move made by Islamic Development Bank in October last year, when it sold US$500m of five-year sukuk – the first such US dollar deal from a foreign multilateral entity in Malaysia. That deal was well distributed into the Middle East, which accounted for 54% of the allocation.

What remains for the Malaysian government to do is to cement its reputation with the Middle Eastern investor base as a hub for Sharia-compliant sukuk issuance. For a long time, Malaysia’s liberally interpreted sukuk structures did not find widespread acceptance among the Arab community. This, however, is now increasingly becoming the exception rather than the norm as Malaysia continues to tweak sukuk structures to meet Middle Eastern standards.

A significant feature of the sovereign’s US$2bn Global sukuk transaction was how it narrowed the gap between its own booming sukuk market and the more conservative Middle East. To enhance its appeal to Middle Eastern investors, it used the Wakala format, which is popular in that region. Under this structure, 52% of the proceeds is invested in Sharia-compliant shares and leasable assets, while the balance is used for entering into a commodity Murabaha arrangement with the government.

In June this year, the chairman of the Securities Commission, Zarinah Anwar – a proponent of Islamic finance in Malaysia – said the growing trade and business links between Asia and the Gulf Cooperation Council created opportunities to expand Islamic finance activities. “Capital investments among countries in the two regions can be enhanced by the availability of Sharia-compliant structures to deepen and broaden the capital markets in this cluster, which can then serve as a model for similar clusters to develop within other regions as well as across regions,” said Anwar.

With solid legal and regulatory frameworks and infrastructure aimed at supporting the sukuk market, Malaysia is acknowledged as one of the most integrated and well-established bases. It will therefore be well placed to take the lead on this cross-border initiative and become a universal sukuk hub, even for Gulf borrowers.

The combined balance sheets of Islamic banks grew globally from US$150bn 1990 to about US$1trn in 2010, with more than 300 Sharia-compliant institutions operating in 80 countries. Source: The Behavior of Conventional and Islamic Bank Deposit Returns in Malaysia and Turkey. Cevik, Serhan, Charap, Joshua, IMF working paper

The sun sets behind the Petronas Twin Towers in Kuala Lumpur