Malaysia is arguably the world’s most important Islamic finance centre. For a country of just 30 million people, Malaysia is the world’s largest centre for sukuk, or Islamic bonds. Just over a fifth of the country’s banking system, by assets, is sharia-compliant, The Economist reports. In comparison, the average for Muslim countries is about 12 percent. Countries in Asia and the Middle East have been determined to set up their own Islamic finance infrastructure in the hope of luring Islamic investors. However, despite a growing global appetite for Islamic finance, these countries have not enjoyed much success. Malaysia’s continual and swift reforms are helping stamp its authority as an unchallenged leader at the fore of the Islamic finance industry.

Malaysia’s status is one that other countries hope to emulate, if not challenge, writes Kit Yin Boey of IFR Asia, a Thomson Reuters publication. Indeed, the country’s liquid ringgit sukuk market is burgeoning, accounting for more than two-thirds of global sukuk volumes. Local Islamic investors are eager for more supplies of Islamic bonds and more diversification. “The Islamic finance industry is still growing – 80 to 90 percent of the work we do in terms of bond issues now are Islamic,” says Lilian Liew, partner at Malaysian law firm Zaid Ibrahim & Co.

A new contender?

The Middle East too has witnessed a spike in international Islamic finance activity, and some industry observers have touted the region as a potential contender to challenge Malaysia. Recent offshore sukuk sales in U.S. dollars from the Middle East feature large deals, including the $4 billion jumbo sukuk from Qatar in July last year. The deal, which Latham & Watkins and White & Case advised on, raised the total international issuance of Islamic bonds to more than $12.5 billion in 2012, according to Thomson Reuters data. This figure far exceeds the previous year’s record volume of $10.6 billion.

But at the same time, companies from the Middle East have also been exploring the ringgit sukuk market to diversify into different funding avenues and currencies. Malaysian lawyers have observed a growing appetite for sukuk bonds in the ringgit market by foreign issuers. “We have seen issuers from other jurisdictions coming to Malaysia to raise proceeds in the form of sukuk. The ones who have come are mainly from the Middle East, but we have also seen issuers who have come from closer by like Indonesia and the Asian region,” says Adrian Chee, partner at Adnan Sundra & Low in Kuala Lumpur.

In November 2012, the National Bank of Abu Dhabi, UAE’s largest lender by market value, issued a 500 million ringgit ($163 million) sukuk – its third in the South Asian currency. The 15-year sukuk also marked the first ever issue of subordinated debt by a non-Malaysian financial institution in Malaysia. And in April this year, Al Bayan, a Saudi infrastructure group, became the first Saudi corporate issuer to raise funds in the ringgit market. “Typically, nowadays we see highly rated issuers coming to the market and they are all doing Islamic finance,” notes Liew. “I am sure the trend of foreign issuers coming to Malaysia is going to continue. Malaysia is the hub for Islamic finance right now,” she adds.

Looking to cash in

Other Asian countries have also expressed intent in creating their own Islamic bond markets. But little has been achieved. Take Indonesia for example. The country, which is home to the largest Muslim population in the world, would be assumed to pose a challenge to its Malaysian neighbour. However, the lack of liquidity in the government sukuk market and the reluctance of issuers to pay a “sukuk liquidity premium” have significantly hindered progress. As a result, only about 4 percent of its financial sector is sharia-compliant, according to The Economist.

Singapore has been the biggest disappointment, argues Boey of IFR Asia. “Despite being well ahead of the other countries in implementing regulations to foster the Islamic finance industry, sukuk issues have been too few and far in between. Also, conventional bonds have served issuers well, while the cumbersome process of setting up sukuk structures has been a major disincentive to local corporations,” writes Boey.

Elsewhere, in a drive to make the territory an Islamic finance hub, the Hong Kong government circulated a public consultation in March 2012 on proposed legislative amendments to facilitate the development of an Islamic bonds market in Hong Kong. The proposals include revisions to Hong Kong’s profits tax, property tax and stamp duty to help place Islamic bonds on a level playing field with conventional financing. The long-awaited draft legislation that provides the taxation framework for Islamic bonds was tabled in December 2012, and the Bill was introduced to the Legislative Council in January this year.

Ahead of the pack

Despite commendable efforts from several countries, Malaysia’s consistent reforms of its finance laws and regulations have helped cement its position as a market leader in Islamic finance. “The government has played a large role in really promoting Islamic finance in Malaysia. Even our government-linked companies are all encouraged to do Islamic finance. I am not sure whether the other governments are as active as that. We also started many years ago, so we probably have a head start,” says Liew.

Chee agrees: “The government and regulators have come out with tax incentives and very helpful clear practical guidelines as to how Islamic finance transactions can be carried out. That is making it a lot more certain for intermediaries to be able to participate in the market.”

Liew and Chee both add that the Malaysian market is seemingly much more relaxed than in the Middle East. In an effort to be more open to international investors, the country is now becoming more GCC compliant. “Malaysia has always been perceived as being slightly more on the cutting edge when it comes to the type of products that investors here are willing to accept,” says Chee. “Some of the earlier instruments or structures that used to be quite popular are no longer so widely used, and structures that are perhaps more well-known in other parts of the world, especially in the GCC, are now more prevalent here” he adds.

Another key development, says Chee, has been the establishment of the International Islamic Liquidity Management Corporation’s (IILM) inaugural short-term sukuk programme this April. The entity is a supra-international organisation, and is responsible for setting up short-term liquidity instruments. According to the IILM, the programme will be “the first sharia-compliant U.S. dollar-denominated short-term highly rated financial instrument in the market to be issued at maturities of up to one year”. It will also be the first money-market instrument backed by sovereign assets in the form of sukuk, and the first multijurisdictional primary-dealer network which will facilitate distribution to investors worldwide. The inaugural sukuk issuance under the programme is underway, and is expected to take place in the second quarter of this year. “I see this as one of the key achievements for Malaysia in this space, and it is something that the Malaysian capital markets can look forward to,” adds Chee.

Furthermore, regulatory reforms are in the works to further expand Malaysia’s Islamic finance industry. “The authorities have been keen to introduce a legal framework to help streamline and promote Islamic finance contracts by harmonising the laws that will govern these transactions within Malaysia,” says Chee. He explains that one of the challenges for Islamic finance has been the potential conflict between the application of sharia law and civil law in Malaysia. Islamic finance transactions have always been done on the basis that the transaction will ultimately be governed by civil law, but will have to be structured in such a way that it is compliant with sharia law. However, the implications of when the transaction turns out to be non-sharia compliant – whether it is still considered a legally enforceable transaction – has not been satisfactorily addressed in the past. According to Chee, parties have used this as a means of trying to release themselves from their obligations, under what would otherwise be a commercial transaction that is governed by conventional law in any case. “So, the authorities have prepared a set of laws to help resolve that question. If such a dispute were to arise in the future after such laws come into effect, there would be a clear framework to point the way forward for the courts to apply that framework, and to ensure that there is no uncertainty,” says Chee. The new laws were slated to take effect in June, but lawyers say that the deadline will likely be pushed back to later in the year.

Consolidating its position

It is important to note that the slow progress in developing Islamic finance-friendly structures in some Asian countries has not dimmed the appeal of sukuk markets, particularly given the jump in Middle Eastern deals. Industry observers acknowledge that attempts to rival Malaysia’s recognised status as the sukuk hub are unlikely to result in overnight success, but steps are being taken in the right direction. It took Malaysia several years to lay the groundwork. Now, coupled with total support from its government and regulators, the ringgit sukuk market is more than likely to stay ahead of its competition as the global hub for Islamic finance.

Malaysia's Islamic insurers hesitant on overseas investment

By Al-Zaquan Amer Hamzah and Bernardo Vizcaino at Reuters

Malaysia is promoting overseas investment through its takaful firms(Islamic insurers) as it seeks to internationalise its Islamic finance industry, but a lack of expertise and low-risk appetite are likely to slow the drive.

The takaful firms currently invest little abroad; a shift from the safety of local assets to better-yielding instruments abroad could boost their profits while increasing demand for sukuk (Islamic bonds) from the Gulf.

Malaysia's takaful firms are already major investors in domestically issued sukuk, holding more than  60 percent of their 19 billion ringgit ($6.1 billion) of assets in domestic private- and government-debt securities as of December 2012, according to central bank data. Assets were up 12.4 percent from a year ago. To encourage cross-border Islamic business, the Malaysian government said last month that takaful operators would be allowed to invest abroad without limit, lifting a requirement for them to hold at least 80 percent of assets locally.

But currently, firms are far below the old limit on foreign investment, suggesting it was not the rules but their own inclinations that curtailed their overseas activities. In some cases, the firms have no foreign exposure at all. “We adopt a prudent approach when considering overseas investments and the appetite for Gulf sukuk is fairly moderate,” said Ahmad Rizlan Azman, chief executive of Etiqa Takaful, Malaysia's largest takaful operator.

The domestic focus is partly due to ample supplies of sukuk in Malaysia; last year the local market saw $103 billion worth of sukuk issued, according to estimates from Zawya, a Thomson Reuters company. “Most of the sukuk issuances (globally) last year were from Malaysia, including some by Gulf companies. If this trend continues, we do not expect significant liquidity to move to the Gulf,” said Azman.

Returns

Another obstacle to internationalisation is the meagre experience of some Malaysian takaful firms; four were set up in the last four years, according to Mohd Faruk Abdul Karim, head of the investment department at MAA Takaful, part of the listed MAA Group. Industry concentration aggravates the problem, with the top three operators holding roughly 90 percent of assets, according to Reuters' analysis of the industry's financials. There are currently a total of 12 firms.

Market leader Etiqa Takaful held 9.5 billion ringgit as of June 2012, about half of industry assets, leaving other firms struggling for scale. Five other firms which publicly reported financials had assets below two billion ringgit each. Etiqa Takaful currently allocates roughly 2.5 percent of assets under management to foreign sukuk, while other firms are believed to have low overseas allocations as well, Azman said.

Dependence on local assets has come at a price, with many takaful firms missing their target returns, said the financial controller of another Malaysian takaful operator, who declined to be named because of the sensitive nature of the issue. “There is a lack of creativity compared to conventional insurers, because the conventional side is a developed market with more intense competition and more pressure to innovate.”

Follow us onTwitter: @ALB_Magazine.