When a country has the world’s largest Muslim population but Islamic banking makes up just 4.8 percent of the country’s total banking assets, something isn’t quite right.

Almost 90 percent of Indonesia’s population of 238 million is Muslim. However, the  11 Islamic banks and the 23 Islamic windows operated by conventional banks in Indonesia accounted for just $21.4 billion (244 trillion rupiah), or 4.8 percent of Indonesia’s total banking assets as of May, according to the Otoritas Jasa Keuangan (OJK), Indonesia’s finance ministry, as reported by Reuters.

The current annual growth rate for Indonesia’s Islamic finance market is 16.5 percent, down from 24.2 percent in 2013, and 49.2 percent in 2011. A large part of this decline can be attributed to the most recognisable instrument of Islamic finance, sukuk, that work similar to conventional bonds, but with sharia principles applied.

In 2011, the Indonesian government had a $1 billion sukuk issuance. The previous year and the one before that (2013 and 2012) saw a combined sukuk issuance of $366 million (4.18 trillion rupiah). In 2014 so far, there has been no Indonesian corporate issuance of sukuk, according to data from the OJK.

The lack of demand is striking, two years after Indonesia’s stock and bond market landed in the cross-hairs of yield-hungry investors emboldened in their search overseas by low interest rates in the U.S, that still remain close to zero.

New blueprint

The OJK is now preparing a new blueprint due at the end of the year to expand Islamic finance in Southeast Asia’s biggest economy.

It says the new blueprint may include additional benefits to current fee and tax incentives to revive the domestic sukuk market, and also said it was considering extending the beneficial issuance fee for sukuk to issuance of sharia-compliant securities.

The document will also address issues in Islamic finance including lack of economies of scale, consolidation opportunities, and the role of foreign ownership.

The OJK had, in early August, also established a committee to enhance coordination between government bodies and the private sector so Islamic banks could better navigate local and federal regulations.

Laksmita Andarumi and Indra Safitri, partner and senior counsel respectively at Melli Darsa & Co, say that while the OJK is taking a step in the right direction, the government also has to take a bigger leadership role together with the National Sharia Board to spark mainstream interest in sharia-compliant financing.

“If the blueprint is implemented, we expect it will better support the sharia capital market development, but we firmly believe this also depends on OJK and the government actively socialising sharia financing as a mainstream, non-religious alternative financing,” say Andarumi and Safitri.

They add that this would require vision, determination, as well as detailed, supportive, and workable regulations, policies and guidelines.

“The development of more Indonesian experts in the field is the key. The government’s push for the sector to grow to a certain percentage of the market will ensure sharia financing will no longer be the ‘step child’ or ‘ignored child’ in general financing in Indonesia,” say Andarumi and Safitri.

“One of the key problems is the lack of human resources – particularly on the regulator’s side – trained in Islamic finance, resulting in a dependency on the National Sharia Board for development of new products,” say Andarumi and Safitri.

“Another problem is that there is no known champion of Islamic finance in OJK. If anything, due to a lack of understanding, some prefer to ignore it. "Leadership is the key to push any initiative in Indonesia,” they add.

Indonesia’s finance ministry knows it is facing bigger problems than just apprehension over taxes and fees, which it says the market already recognises that it provides incentives for.

“Taxation should not be an issue. Right now, the biggest challenge in our sukuk market is the issuers’ and underwriters’ lack of knowledge and understanding on sharia products,” it said recently.

A lack of understanding of Islamic finance, not just for investors, but also for issuers and underwriters in Indonesia, is a formidable opponent when combined with widespread apathy for a sector that many Indonesians see exists to fulfill religious beliefs.

“One aspect of marketing and possibly education is to get people to understand that Islamic finance is not just for the Muslim population and should be viewed as providing another form of financing,” says Noor Meurling, senior foreign legal consultant at Oentoeng Suria & Partners (OSP) in Jakarta.

“The term Islamic finance may give it a stronger religious connotation thereby restricting interest in its use for general transactions,” says Meurling.

Andarumi and Safitri also call for non-Muslim finance experts  to get involved in the sector to make it clear that Islamic financing is not only reserved for Muslims.

Need for clarity

Then there are problems such as the lack of regulatory clarity, and the lack of experience even for arranging banks. Indonesians themselves are split over which Islamic finance model is acceptable.

Melli Darsa's Andarumi and Safitri say many Indonesians that are active in  Islamic finance prefer not to look at Malaysia’s model of Islamic finance, claiming that it is too advanced and not conservative enough, and say that Saudi Arabia’s version should be used instead.

“This debate as to which kind of Islamic financing should be our reference is part of the reason Islamic finance here has not advanced. People still associate Islamic finance as more of a need to fulfill religious rules rather than a way to provide a wide array of innovative products,” they say.

To create a solution  it hopes will capture the imagination of the broader market, the OJK has appointed a committee to develop sharia finance in Indonesia.

OSP's Meurling says that the Islamic finance model that is developed in Indonesia will likely be a balance between the Malaysian and the Middle East concepts.

“The committee is constituted from various sectors representing social, financial, and religious interests,” she says.

There is also the continuous need to re-evaluate products for compliance with sharia principles.

Take sukuk for example, most Islamic bonds  are issued on “beneficial” or “asset-based” ownership to investors.  This means that while investors have the right to use and obtain cashflow generated from the underlying asset, they cannot sell the asset to a third party as legal ownership of the asset still remains with the issuer of the sukuk.

Sharia law currently recognises that a valid sale, or “true sale,” is one  which all rights to an asset are transferred by the seller to the buyer, and this includes the right to sell the underlying asset to a third party.

To maintain the credibility of the sector, there have been calls for the Islamic finance industry to relook the issue of whether ‘beneficial ownership’ is compliant with sharia law, and whether based on sharia, such a sale can even be considered a valid sale in the first place.

“Islamic finance is not, of course, appropriate for everything and strict principles as well as sharia compliance are fundamental. But it can be used for a wide range of purposes including infrastructure-type transactions where investors can benefit from long-term revenue derived from the project while sharing risk with the owner,” says Meurling.

Indeed the confirmation of the reform-friendly Jokowi as Indonesia’s new president, together with OJK’s new blueprint, could provide the sector with a much-needed catalyst.

Jokowi had already stated, even during his early campaigning days, that rapid infrastructure development and improvement in Indonesia would be a key pillar of his presidency.

This ties in well with the sharia principles on which sukuk are based. Islamic bonds for example, must link return and cash flow from financing to purchase assets, as sharia law prohibits trading in debt. This means investors can finance non-speculative identifiable assets.

Power plants, oil fields, or real estate used for purposes that do not breach sharia law, are large projects that fall into such categories, and investors can also share in the revenue generated from such assets.

“Sukuk is already relatively successful in Indonesia so I expect with some adjustments allowing for risk control, it will get a larger appreciation,” says Meurling.

The sukuk market is forecast to grow 14 percent to $130 billion in issuance in 2014, compared with last year, a Thomson Reuters study shows.

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Asian governments join sukuk rush

By Kit Yin Boey of IFR

Hong Kong, Indonesia and Pakistan are banking on pent-up investor demand as they look to raise up to a combined $3.5 billion in the fast-growing Islamic bond market.

The three sovereign sukuk issues, including a planned $1 billion debut from Triple A rated Hong Kong, are set to launch before the end of September.

Few Asian issuers have targeted the global sukuk market in the past, and the glut of deals comes as governments across Asia are looking to attract Islamic investors from outside the region.

"There are a lot of Islamic investors from the Middle East looking for diversification and new investment opportunities," says Ahsan Ali, Standard Chartered Bank's managing director and global head for Islamic Origination.

"Historically, these investors were mostly investing in Europe and U.S., but over the past few years, we have seen growing investment allocations to Asia as they move to diversify their assets," Ali says.

Indonesia, home to the world's biggest Muslim population, is Asia's only regular issuer in the global sukuk market, having issued annually since 2010. Pakistan has sold Islamic debt overseas only once before in 2005, while Malaysia has typically preferred to target its own domestic market.

The addition of more Asian sovereigns to the market comes amid growing interest in the sukuk format among borrowers across the globe. The UK priced its first sukuk this year, while Luxembourg, Tunisia, South Africa are among other governments considering a debut.

"This year has been unique with issues coming from outside the traditional market in the Middle East," says Mohammed Dawood, HSBC's global head of sukuk financing. "The UK government sold a 200 million pound ($336 million) bond in June, and other sovereigns are looking at the market.

"This helps to internationalise the product as a mainstream instrument that can be used as an alternative funding source."

For Islamic investors, the boost in supply cannot come soon enough. Ernst & Young projects the growth of the Islamic banking industry will drive demand for sukuk to $900 billion in 2017, up from $300 billion just over a year ago. Globally, assets held by Islamic investors rose to $1.8 trillion at the end of last year, marking an annual growth rate of about 17.6 percent over the last four years.

Setting benchmarks

Asia's sovereigns view the upcoming offerings as an opportunity to set benchmarks for companies to follow, as well as a chance to expand their own investor base.

Hong Kong is expected to sell a $500 million to$1 billion sukuk in September via joint leads CIMB, HSBC, National Bank of Abu Dhabi and Standard Chartered. Conventional as well as Islamic investors are likely to snap up the debut from a rare Aa1/AAA/AA+ rated issuer.

"If [conventional] investors want access to a certain credit, and if sukuk is the only way they can get hold of the credit, they will definitely buy it," says a Kuala Lumpur-based debt banker.

Bankers hope Indonesia can beat Hong Kong to market with a U.S. dollar sukuk of up to $1.5 billion in late August, after the end of Eid al-Fitr, the festival marking the end of the Islamic holy month of Ramadan.

Roadshows are planned for the middle of August. Indonesia is rated Baa3/BB+/BBB-. CIMB, Emirates National Bank of Dubai, HSBC and Standard Chartered are joint bookrunners.

Pakistan, with the lowest rating of the three at Caa1/B- from Moody's and Standard & Poor's, will appoint lead banks in the coming days, according to a finance ministry official.

Cheaper funding

While Asia is home to the world's biggest Islamic bond market, in Malaysia, Asian issuers have traditionally had a low profile overseas. The only global offering this year was a $300 million 2.874 percent five-year deal from the Export-Import Bank of Malaysia, while last year, there were only two in U.S. dollars - a $800 million dual-tranche from Malaysia's Sime Darby and a $1.5 billion issue from the Republic of Indonesia.

Other Asian borrowers have taken note of Malaysia Exim's result, however. The bond priced inside its conventional U.S. dollar curve, showing that the Islamic market can deliver cheaper funding. Some issuers in the Gulf region have sold sukuk in global markets at yields of between 10bp and 20bp lower than their conventional bonds.

Sukuk issues are also performing well. The Dow Jones Sukuk Index is up 4.39 percent so far this year compared with a return of 0.22 percent in 2013.

Market participants hope high-profile offerings from key Asian sovereigns will allow other borrowers to benefit.

Hong Kong, in particular, is looking to promote itself as a regional hub for Islamic financing to capitalise on growing trade links between Greater China and the Middle East. Trade between China and the Middle East reached $238.9 billion in 2013, up from $25.5 billion in 2004. Malaysia's Khazanah Nasional and Axiata have already sold sukuk denominated in offshore renminbi in Hong Kong's dim sum market.

"For Hong Kong to pass the sukuk-related ordinance [in March] is a positive development for the overall Islamic financial market," says Michele Leung, associate director, fixed income indices, S&P Dow Jones Indices.

"Both local and global investors want to diversify their portfolios."