The growing and deepening market for Islamic financing especially in Asia could be an ideal conduit to finance the regions’ burgeoning infrastructure sector. This especially in the current volatile state of the world’s lending financial markets which has made the task of funding infrastructure developments, whether power stations to railways, even harder.
So says, international credit rating agency, Standard & Poor’s Ratings Services, in a report titled “Will Islamic Finance Play a Key Role in Funding Asia’s Huge Infrastructure Task?” which was published last week.
“This issue,” stressed the report, “is particularly pertinent for Asia, which is struggling to keep up with the escalating infrastructure needs of the region’s surging population amid solid economic growth.
With the outlook for global lending markets still uncertain, part of the solution for Asia may lie in finding alternatives to conventional financing. Islamic finance is one such alternative.”
The authors of the report also believe that infrastructure projects are a logical fit for Islamic finance, which is governed by Shariah principles and predicated on asset-backing and shared business risk. Indeed, “the asset-backing nature of Islamic financing may provide a better funding match for infrastructure projects than traditional lenders, such as banks.
What’s more, sukuk investors typically have an appetite for longer tenors than bank loans, and prefer stable and predictable cash flow — traits that are typically associated with infrastructure projects,” maintained the authors.
Governments across Asia are making moves to create a more attractive investment climate for infrastructure-related investments, including the promotion of Islamic financing, and are forging greater co-operation between each other and multilateral agencies to accelerate spending in infrastructure.
However, the international rating agency does has some doubt whether the Islamic finance industry can rise to the occasion and contends that “Whether Islamic finance plays a significant role (in infrastructure financing) remains to be seen.”
Islamic finance, especially structures such as Sukuk, and infrastructure should be a natural fit. While the sukuk market has flourished over the last four years, these have concentrated more on raising finance for balance sheet purposes; refinancing existing more expensive debt including very often conventional finance debt; overcoming the mismatch between short-term deposits and longer term liabilities by raising longer term financing; and providing working capital and funds for expansion
Sukuk for development and infrastructure projects such as pure project sukuk have been hardly a feature of the sukuk landscape, although there have been a few exceptions. This is surprising given the estimated multi-trillion-dollar infrastructure spend in the member countries of the Islamic Development Bank (IDB) Group over the next decade or so.
According to Asian Development Bank estimates, the Asian economies will require $8 trillion over the next decade or so to fully address the region’s basic infrastructure needs, including developments in areas such as water, transportation, and power generation, for which demand in particular is set to increase significantly.
There is no doubt that the Asian economies, especially China, India, Indonesia and Malaysia will be key drivers of global economic growth. This in contrast to the US and Europe, where GDP growth has flatlined, and is struggling to achieve even a one percent growth rate in the economy.
Asia, which already accounts for more than a half of the world’s population, is predicted to see a further surge in population which in turn will put pressure on almost all the countries to build new and upgrade existing infrastructure.
In fact, the S&P report says that there is plenty of evidence to suggest that governments are focusing on the significant infrastructure task that lies ahead and channeling long-term funds to accelerate much-needed infrastructure-related projects.
Indeed, governments across Asia are showing greater cooperation to accelerate infrastructure spending in the region and find alternative sources of funding. For instance, in September 2011, the Association of South East Asian Nations (ASEAN) announced the creation of a new fund to help finance major infrastructure projects across the region; the fund’s total lending commitment through to 2020 will be about $4 billion, rising to more than $13 billion when ADB’s projected 70 percent co-financing is included.
Similarly, the IDB and ADB also set up a $1 billion Islamic infrastructure fund last year to co-finance such projects in member countries common to both multilaterals.
The IDB’s own standalone Infrastructure Fund also invests through private equity placements in infrastructure companies including in Asian member countries such as Malaysia, Pakistan, Indonesia, Bangladesh etc.
While banks – both commercial banks and multilateral development banks – have traditionally provided infrastructure financing, raising funds through the capital markets through the issuance of commercial paper such as bonds, Islamic trusts certificates (sukuk) and initial public offerings (IPOs) is now increasingly taking off.
Not surprisingly, Asia like other regions in the world are encouraging greater access to local capital markets through regulatory changes and tax amendments to promote a much more diverse and liquid local bond/sukuk market.
S&P’s suggestion that the principles of Shariah are a good fit with infrastructure spending, and that sukuk could play a key role in financing Asia’s infrastructure funding gap, is hardly new.
Malaysia and the MENA countries have for instance accessed Islamic infrastructure financing including project finance, Istisna financing and sukuk for projects ranging from airports development, toll roads, oil and gas infrastructure, building of refineries and even the building of an athletes village and allied infrastructure for a major regional games event, the Asian Games.
In his budget 2011 speech in his capacity as finance minister and at the launch of the government’s Economic Transformation Program (ETP) in 2010, Malaysian Prime Minister Mohd Najib Abdul Razak urged government owned and government linked companies to increase their Shariah-compliant investments as part of their investment portfolios both at home and abroad in search of portfolio diversification and more competitive returns; and to raise funds through the issuance of sukuk.
Last month for instance, Syarikat Prasarana Negara Berhad, the Malaysian public infrastructure company wholly-owned by the Ministry of Finance, successfully priced its RM2 billion 7-year 10-year and 15-year Islamic Medium Term Notes issued last week under its RM4 billion nominal value sukuk program.
The sukuk program, whose proceeds will be used mainly to part finance the Kelana Jaya and Ampang LRT Line Extension Project (LEP) and other infrastructure improvement initiatives by Prasarana, is guaranteed by the Malaysian government.
The offering was structured as a Sukuk Al-Ijarah (leasing sukuk), which according to Parasarana, involves a sale and leaseback of Prasarana’s railway assets, which the company would re-purchase upon maturity of the sukuk.
It is Prasarana’s obligations in relation to the payment of the rentals and the re-purchase price that are guaranteed by the Malaysian government. Parasarana indeed was set up to facilitate, undertake and expedite public infrastructure projects approved by the government and together with its group of companies are also asset-owners and operators of several public transport providers, namely the Ampang and Kelana Jaya lines, KL Monorail system, bus operations in Klang Valley and Penang, as well as the cable car services in Langkawi.
The above issuance was the first time that the company had tapped the Islamic capital market with a sukuk offering, and according to Prasarana Chief Executive Officer Shaipudin Shah Harun, there will be further finance raising forays in the future to fund the company’s expansion plans, and Parasarana is committed to contribute to the further development of the Malaysian sukuk market. As S&P alluded in its report, there is latent strong appetite from investors for sukuk.
The Parasarana offering like others originated in Malaysia was four times over-subscribed by a broad range of investors, including insurance companies, fund managers and financial institutions.
The dynamics of the Asian infrastructure market is well suited to Islamic finance. Asian infrastructure projects such as power plants and toll roads, according to the S&P report, once completed, typically benefit from long-term concession agreements of 15-to-20 years or beyond that usually offer stable and predictable cash flow.
These are the sorts of traits that Sukuk investors, which are typically buy-and-hold investors, tend to prefer. On the other hand, bank loans typically have tenors of five-to-seven years, which in many cases translate to a poor match for infrastructure projects. Indeed, the short tenors of bank loans may introduce refinancing risk for these sorts of long-term developments.
Other reasons why bank lending may be retrenching from funding infrastructure-related projects include provisional proposals under The Basel III regulations on more stringent capital requirements and greater risk management which may serve to limit the flexibility of banks to lend to infrastructure projects and put then increasingly under pressure to shorten maturities, reduce capacity, and charge higher interest rates.
“In our view, this creates further risks for infrastructure funding. The upshot is that infrastructure developments may have limited access to bank funding as the regulations are rolled out,” says the S&P report.
The euro zone sovereign debt crisis, and the exposure of the European banks to such debt, will also impact negatively on the ability of European banks in financing infrastructure. European banks have been active lenders to infrastructure companies and projects in Asia.
The report contends that Malaysia, a pioneer in using Shariah-compliant sukuk to fund infrastructure projects, is leading the way in terms of Islamic financing and has introduced laws that provide favorable tax treatment for Islamic finance assets in Sukuk offerings.
Asian economies can benefit from Malaysia’s example, especially some countries with large infrastructure requirements that do not have a developed
local bond market, such as Indonesia, Philippines, Vietnam, and India. Indonesia is probably in the best position to benefit from Islamic finance, given that it has already put in place regulations for such transactions.
“Malaysia and Singapore are the two markets best positioned to play the role of hubs for Islamic infrastructure investing and promotion. Singapore can provide the advice and technical know-how to companies embarking on infrastructure projects, while Malaysia can provide the necessary infrastructure to raise Islamic capital for the funding of these projects,” concludes the report.
The authors predict a proliferation of hybrid Sukuk but warn that the lack of standardization may constrain sukuk issuance and may deprive the market of an organized structure to facilitate secondary trading and liquidity.
While recent developments point to some regulators introducing initiatives to implement a more cohesive global market for sukuk, the reality is that the industry is still several years away from a more standardized market globally. Until this issue is addressed, the market is unlikely to reach its full potential compared to conventional debt markets.
The issue of guarantees or purchase undertaking in certain types of sukuk may also be a dampener, but with talk by the International Islamic Corporation for the Insurance of Exports Credits and Investment (ICIEC, the stand alone export credit agency of the IDB Group, of setting up a third party Sukuk Guarantee Fund, this may be mitigated and provide potential sukuk investors with more security and confidence.
Despite the above constraints, S&P believes there is cause for optimism for the role of Islamic finance in infrastructure financing. The sukuk industry is expanding gradually and is now moving toward listed instruments both in international and local markets, including Dubai, Malaysia, and Saudi Arabia.
This trend to list Sukuk in organized markets is important for market liquidity, with bigger pools making it easier for investors to manage liquidity and price discovery. There is also potential for the development of secondary markets for trading sukuk, which will likely provide more comfort for investors.
Similarly, the default by a small number of sukuk during the global financial crisis, and their subsequent restructuring, is a positive development, as it allowed maturation of the industry. A default track record, added the S&P report, “is necessary for the establishment of a mature market.
Defaults help investors form a view of the credit risk of instruments, especially asset-backed sukuk without any guarantees (the main structure used in project financing).”