Sukuk: A key to building Asia’s critical infrastructure

By Thiam Hee Ng on Thu, 10 April 2014

The global market for sukuk –or Islamic debt securities– has soared from a tiny US$15 billion in 2001 to US$281 billion in 2013, led by Malaysia which now accounts for just under 60% of the total outstanding securities. Issuance from the Middle East makes up a further 30%. Overall, sukuk still represent a fraction of Asia’s total bond markets but there is huge potential for it to grow and to help finance the roads, power stations and other infrastructure the region urgently needs.
 
Helping issuers tap the large pool of funds seeking shari’ah-compliant investments would help lower the cost of financing infrastructure, while the innovative profit-sharing structures of some sukuk could also lower the risk of financing such projects.
 
Why should we think about this now? Unfortunately, bank financing for long-term infrastructure projects has become much less attractive under the new Basel III rules. That means those seeking to finance infrastructure are starting to turn away from banks toward the bond markets, which can help tap long-term institutional investors such as pension funds and insurance companies.

Projects to build tollways, railways or even schools and hospitals, which generate revenues from tangible assets, are consistent with the Islamic finance rules of creating economic value and so are particularly appropriate for sukuk financing. Moreover, Malaysia provides a fine example of how project financing can be done successfully through Islamic debt securities.
 
Unfortunately, such financing has failed to take off outside Malaysia. That’s partly because other economies haven’t yet developed stable regulatory frameworks and economic environments which encourage investment in sukuk. Underdeveloped markets for standard bonds also discourage infrastructure projects from seeking new types of fund-raising.

Another impediment is the lack of consistency in shari’ah guidelines for structuring Islamic financing for infrastructure projects. Different markets and even different Islamic financial institutions have different guidelines. So borrowers can’t be certain that a financing structure which is acceptable to one Islamic bank will be acceptable to others, particularly if they are in a different country. Creating a standard set of Islamic debt structures and rules understood by all investors and borrowers would  help make sukuk more popular.

So far, most sukuk use the murabahah or ijarah structure because they are similar to conventional bonds in the sense that they offer certainty of returns. However, promoting the musharakah profit-sharing structure may, in the long term, prove more useful for those looking to finance infrastructure and more work could be done in this area.

A musharakah sukuk sees the investor and issuer share the profits —or losses— resulting from the performance of the underlying infrastructure projects. From an Islamic perspective, these types of sukuk are more desirable because of the shared risk and reward. Moreover, the musharakah structure can help reduce risk for issuers in financing infrastructure projects as there is no fixed claim on the cashflow from the projects. This is particularly important for infrastructure projects where the revenue flows may be volatile and uncertain. Sukuk investors, by sharing risks with the issuers and reducing their debt servicing obligations during difficult periods, will help reduce the risk of default. In return for bearing the extra risk, investors benefit by getting a higher rate of return.
 
In addition, the region needs to ensure that sukuk are not treated unfavourably by tax and regulatory regimes. Since existing tax and regulatory frameworks in most countries weren’t designed with Islamic products in mind, Islamic financial products tend to be at a disadvantage compared with conventional financial instruments.

Addressing these constraints isn’t easy. But if we do, we should see sukuk play a key role in helping Asia build the infrastructure it sorely needs to continue to grow and prosper.