Indonesia’s sukuk will be a Shariah landmark

Asiamoney, September 2008

One would expect the world’s most populous Muslim country to be at the forefront of Islamic finance. It isn’t. But the catalyst that observers have been calling for for years to spur growth in Indonesia – a big Islamic capital markets issue from the country itself – has finally arrived, raising hopes that the industry will grow rapidly from here.

In August, Indonesia as a sovereign launched a Rp4.7 trillion sukuk – the Islamic equivalent of a bond – in a domestic deal. Next month [OCTOBER], it will hit the road to pitch a global sukuk that could raise as much as US$1.5 billion. These are important deals for a variety of reasons: their contribution to Indonesia’s budget deficit, the opening of a new source of federal funding, and the creation of a benchmark to aid corporate sukuk and Islamic money market issuers. But more than anything, they are a clear statement of intent.

“It’s a very important step,” says Adrian Gunadi, head of Shariah banking at Permata Bank in Jakarta. “It shows that the government itself is committed to promoting Islamic finance in Indonesia, and hopefully it will create a stimulus for corporates to issue sukuk in the future.”

To illustrate the importance of the new deals, it’s useful to understand where Islamic finance stands in Indonesia today. Despite being home to 225 million people, 85% of whom are Muslim, Indonesia’s Islamic banks account for just 2.1% of the total industry, or Rp42 trillion in assets, according to Bank Indonesia. Prior to the sovereign domestic issue, sukuk accounted for about 2.5% of total bond issuance, and Shariah compliant mutual funds, 1.7%.

It’s actually growing quite fast – the bank asset figure was just 1.6% in 2006 – but proportionally is far lower than, for example, Malaysia. There, Shariah-compliant assets account for close to 15% of the total banking market, 10% of unit trusts by net asset value, and in 2007 sukuks accounted for 76.4% of total bond approvals, according to Malaysia’s Securities Commission.

It’s common to blame an inadequacy in regulation for this lag. But, while that was certainly a reason for the delayed arrival of a sovereign sukuk, it’s not true that Indonesia has had no legal structure for Islamic finance. There is an Act from 1992 that allows the existence of a dual banking system in Indonesia, and the country’s first Islamic bank, Bank Muamalat Indonesia, was founded that year. The first mutual fund, from Danareksa Investment Management, appeared in 1997, and Bank Indonesia’s oversight of the Islamic banking system was given legal form in 1999. And although the sovereign has been absent from the domestic bond markets, Indonesian corporations have occasionally been active: the first, Indosat, launched a sukuk in 2002.

Instead, it’s more likely that Indonesia has simply had an awful lot more to do than get Islamic finance rolling. Surely no country suffered quite so much as this one in the Asian financial crisis a decade ago, and one could argue that the restructuring effort in the country’s financial services industry continues to this day. Banks have been nationalised, privatised, closed, opened, merged, hived off and generally preoccupied consistently since the 1990s; there is surely no busier portfolio in Asian politics than that of Indonesia’s finance minister, Sri Mulyani Indrawati.

So where does a sukuk fit here? We can see from other countries in the region that a sovereign sukuk – and particularly a global – has a considerable galvanising effect on the development of Islamic finance in a country. Asiamoney’s in-depth coverage of Islamic finance really started on the back of Malaysia’s US$600 million global Islamic FRN through HSBC in 2002, the first ever international Islamic bond. While Malaysia had been a home to Islamic finance for years beforehand, the world really started to take notice with the sukuk, and the progress in the country’s Shariah-compliant industry – and in particular its bond market – has been dramatic ever since. Similarly, the most recent global sovereign sukuk, a US$600 million issue for Pakistan in 2005, also helped to cement the sense that Pakistan, after a slow start of its own, was serious about building Islamic finance there. It hasn’t looked back.

For Indonesia to get moving, a vital piece of legislation first had to get through parliament; this was Law No.19/2008 regarding State Shariah Securities, which passed through the House of Representatives in April.

Rahmat Waluyanto, director general of debt management at the Indonesian Ministry of Finance, reckons he started work on getting things ready for this sukuk launch back in 2002. “There were several laws that did not allow things like the use of government assets to be used as collateral, so we had to find a sustainable legal framework for the sukuk,” he says. “First we tried to convert the conventional bonds into sukuk by changing their contracts, but it was not feasible.” Special government regulations, distinct from legislation, were also considered but were not suitable for the long term growth of the sector. “We need to create underlying laws that are permanent, that can give a basic legal and regulatory framework for government to manage sukuk – which means not only issuing the sukuk but any other activities related to it, such as buybacks, switching and so on.” That law, as wide-ranging as they could get it to be, is what finally passed this year. “By having that one law, the government has the authority to do anything: not only to issue any kind of sukuk structure, but also to set policies in developing the domestic sukuk market.”

Among the vital elements of this law are a clear understanding of appropriation, which guarantees investors that the government will always repay any obligation arising from a sukuk issue. Another point concerns approval: parliament must be asked ahead of issuance of sukuk, as well as for approval on the use of government assets to underpin them. Other elements of the law cover coordination with the central bank, as the central custodian for the ministry of finance (and also its payment agent); coordination with the Ministry of National Planning, which is responsible for providing the ministry of finance with projects that can be used as the underlying of sukuks; and the establishment of special purpose vehicles, which are commonly used in sukuks. There’s also sections regarding secondary market trading. Listing to Waluyanto reel off the list, it’s less surprising that the legislation has taken half a decade to get through.

But with it done, work began on the sukuks. First there needed to be some assets to underpin them, and the Ministry of Finance didn’t have to look far: it used its own office, and the government land around it, representing Rp18 trillion of assets, or about US$2 billion.

With law and assets decided upon, Waluyanto and his team set off on a non-deal roadshow in April to the Middle East, stopping off in Dubai, Riyadh and Jeddah to assess the potential there, finding it “very promising”. This trip seems to have cemented in their minds that they should do an international as well as a domestic deal.

First cab off the rank, though, was a domestic deal. Three local houses, Danareksa Sekuritas, Mandidi Sekuritas and Trimegah Securities, were appointed, and the deal was launched on August 15, with the public offer closing on the 21^st. A seven year and a 10-year tranche were offered, longer than the five-year deals common from sovereigns.

A total of Rp8 billion of demand came in, although some of it was chasing higher yields than the government was prepared to offer and fell away when the final yield was decided on: 11.8% for the seven year, and 11.95% for the 10. (While that looks generous, it is worth remembering that inflation in Indonesia stands at around 11%.) In the end, the government took Rp4.699 trillion, less than the Rp5 trillion that had been talked about in the market, but certainly a significant deal.

Waluyanto says the government was “very happy” with the deal, which he calls “a great success, at about the right price. We didn’t add any additional risk premium for the first issuance.” 88% of the deal was sold domestically (roughly the reverse is common in conventional bonds). Another difference from conventional issuance was that whereas banks are usually the dominant buyers of conventional bonds, they came in second on the sukuk after insurers. (Retail were a negligible component and not really targeted, although Waluyanto says that next year a retail sukuk will be launched).

Perhaps the most striking thing about the domestic deal’s distribution was the fact that Shariah banks made up less than 10% of the total. In one measure this is perhaps just a reflection of the fact that there aren’t many Shariah banks yet, but it also shows there was a clear market among conventional banks for these securities, something the ministry is taking as a very positive message. “This should encourage the government to do more in developing the sukuk market here in Indonesia,” Waluyanto says.

Next step is the international deal, for which Standard Chartered, HSBC and Barclays Capital have been mandated. In the markets people are talking about a US$1.5 billion deal, but that is in fact the maximum that can be done, and is a figure probably reached by subtracting the proceeds of the domestic deal from the value of the buildings that are underpinning the sukuks. In fact, Waluyanto seeks to dampen expectations, saying “the target may be less, as this is our first issuance. And we have to be conservative.”

The mandate was hotly contested; it is understood that 10 banks were originally under consideration, then whittled down to six, with Citi, Deutsche and Lehman Brothers the unlucky ones who did not make the final three (at least one regional name, Malaysia’s CIMB, is believed to have been in the original 10). The common British origin, or at least legal domicile, of the three selected names raised some eyebrows, but they are believed to have been selected because of their abilities in the Middle East. HSBC and Stanchart are older than some of the countries themselves in the GCC, while Barclays has built strongly in the region.

Finance minister Indrawati will be in Dubai in early October for a non-deal roadshow of sorts. Then the borrower and leads will all set off on a formal roadshow in October, which will include at least one Asian location (one assumes Kuala Lumpur, though this had not been decided at the time of writing); possibly London; and certainly a number of cities in the Middle East, which is where the vast majority of demand is expected to come from. Waluyanto is expecting a good response from conventional investors as well as those who only want sukuk, and hopes they will generate some activity in the secondary market, which so far has been exactly what sukuk issuance has been lacking.

This will be the first global sovereign sukuk since Pakistan’s in 2005, so there should be a lot of built-up appetite. Structurally, like the domestic deal, it will take the ijarah form – basically a structure built on leasing – and may offer two or three tranches of different maturities.

These deals will have a number of knock-on effects. Most obviously, they will bring in much-needed funds to the government. “There is a growing need for the state to fund the growing budget deficit,” says Waluyanto; the revised 2008 State budget deficit is equivalent to 2.1% of GDP.”We cannot rely on conventional instruments such as bonds, and are now diversifying our investments. It seems that the capacity of the market for conventional is diminishing, and we see there is huge potential demand from sukuk investors.”

They will also create benchmarks for issuance. This ought to prompt not only easier capital raising by corporate or institutional borrowers, but also the development of money market securities, which will help the fledgling Islamic banking sector in Indonesia, as well as providing an additional monetary management tool to the central bank. Indonesian corporates are likely to take advantage not only of the domestic benchmark but the international one too, since any conventional form of debt capital raising in dollars or other G3 currencies has become all but impossible to Indonesian credits in this environment.

The International Islamic Financial Market, a Bahrain headquartered but multilateral group tasked with building the Islamic capital markets, is pleased to see Indonesia’s arrival. “It’s needed, especially in terms of creating the money market,” says Ijlal Alvi, the CEO. “We hope the sovereign can take a leading role in issuing, because up to now what we have seen is pretty much driven by the corporates.”

There are further knock on effects. “Apart from the benchmarks for future issuance, there are a lot of derivative products we can create,” says Gunadi at Bank Permata. “You can create deposits linked to the returns of the sukuk, for example.” While persuading any corporate to borrow money today is a challenge, “I think we can pitch the client that through the sukuk you can widen your investor base,” he says.

Getting the derivative products away would require more engagement with the regulators, though. Gunadi talks about profit rate swaps and forwards, but says: “It’s at the very preliminary stage in Indonesia. There are several regulatory hurdles, and the opinion from the national Shariah council would need to be reviewed.” In some countries a structure called commodity murabaha is permitted (though not without controversy – some consider this a breach of the spirit of Islamic finance), and this structure can be used to underpin derivatives, but it is not allowed in Indonesia at this stage. Still, “There is a huge need for this product, especially in Islamic banks as their balance sheets grow bigger,” says Gunadi. “You would see the importance of these instruments to mitigate market and interest rate risk.”

For the future, Indonesia plans more sukuks, including a retail deal early next year. It also hopes to move away from ijarah and launch project-based sukuks, with the national planning agency pulling together some suitable projects to underpin them, chiefly in infrastructure. (This serves an additional need: anything which helps fund infrastructure in Indonesia has to be a good thing.)

For Islamic banks in Indonesia, further growth also requires heightened awareness. A great many more Muslims may be attracted to Islamic accounts if only they know they exist. And there is plenty more to be done: tax laws and other peripheral legislation needs to be adapted or streamlined; Indonesia needs a greater stock of established and respected Shariah scholars; and the provision of training to Islamic finance professionals needs work.

But a sovereign sukuk brings evidence that the people at the top care about Islamic finance, a message which – as has happened in Malaysia – can set the whole sector running. “There’s tremendous potential in Indonesia,” says Alvi. “Previously maybe the delay was that it was not really coming from the top down. But now there has been a lot of effort by the central bank and the government to promote Islamic finance, which I think is good.”

“It took a while, but it’s on the right track,” says Gunadi. “My view is there is now greater support from the government from Islamic finance, but it has to be a coordinated effort between the central bank, the government, the tax office – all the stakeholders have to play their role. It’s moving at its own pace.”