‘Time is ripe’ for Islamic finance in Asia, says S&P

In a new report, the rating’s agency has highlighted the crucial role that Islamic finance could play in funding Asia’s huge infrastructure needs. The region will, however, need to learn the lessons of Malaysia’s approach to regulation.

Given the current “jittery state” of the world’s lending markets, a new report from rating’s agency Standard & Poor’s concludes that “the time seems ripe for more Islamic finance funds being channeled into much-needed infrastructure projects across Asia”.

The report says that lending difficulties are particularly pertinent for Asia given the region’s surging population and economic growth and the constant pressure that this places on infrastructure. The Asian Development Bank recently estimated a funding need of $8 trillion over the next decade just to address basic needs. Therefore, says the report, alternative solutions to “conventional financing” need to be found and that Islamic finance is “one such alternative”.

S&P claims there is a “growing and deepening” market for Islamic financing and that it offers a “logical fit” with infrastructure projects. This is because it is governed by Sharia, which emphasises asset backing and shared business risk. Moreover, investors in Islamic finance typically have an appetite for longer tenors than those offered by bank loans, as well as stable and predictable cash flows.

The report cites Malaysia as a pioneer in using Sharia-compliant sukuk bonds to fund infrastructure projects and says it has created a “very attractive” environment for Islamic finance investors, especially through laws that provide favourable tax treatment. It says that countries with a large infrastructure requirement but without developed local bond markets – such as Indonesia (where some progress is recognised), Philippines, Vietnam and India – could benefit from Malaysia’s example.

For Islamic finance to “attract market interest and prosper” the report says regulatory frameworks are needed to create a level playing field with conventional finance. As well as hailing Malaysia’s tax initiative, it also recommends that Malaysia and Singapore play a role as hubs for Islamic finance – Malaysia for its ability to raise Islamic capital, and Singapore for its advice and technical know-how with respect to projects.

The key issue in whether Islamic financing of infrastructure will reach its full potential is “the lack of standardisation which constrains sukuk issuance and deprives the market of an organised structure to facilitate secondary trading and liquidity”, according to S&P. While some regulators have recently introduced measures to promote a “more cohesive” global market for sukuk bonds, a standardised market is still “several years away”.

Another constraining factor identified by the report is the lack of asset-backed sukuk structures with no guarantees from project sponsors. This is a problem for standalone infrastructure projects, which typically involve ringfencing of the project with recourse to cash flows and underlying assets but not to sponsors. The report authors think this is because sukuk transactions without guarantees may be lengthier, costlier and more complex.

Overall, however, the report concludes there is “cause for optimism”. Reasons for this optimism include: the move towards listed Islamic finance instruments in both international and local markets; the emergence of big pools of sukuk bonds in organised markets, making it easier for investors to manage liquidity and price discovery; potential for the development of secondary markets; and the contribution of sukuk defaults during the global financial crisis to the maturation of the industry.