Opportunity knocks on the Islamic front

A number of airlines have started to use Islamic finance structures

According to credit rating agency Standard & Poor's, which rates it AAA, the IDB could write off all its receivables and investments and remain solvent without a capital call.

Although this strength is impressive it also indicates that the bank is simply not providing enough development assistance - it is sitting on a pile of cash it doesn't know how to mobilize. And in this respect, as well as in its stringent upholding of the Shariah, the IDB is perhaps the defining example of an Islamic bank today.

In 2002, ABN Amro Private Equity estimated that Islamic banks were 40% more liquid than conventional banks. Figuring out productive uses for the money flowing in from religiously motivated customers is still a problem. The Liquidity Management Centre, established in Bahrain last year to provide an active market of short-term liquidity instruments has not yet solved it.

Leading Islamic banks in the Middle East have recorded an average of 15% growth in assets since last year. In Malaysia all the domestic banks look likely to exceed the government's target that 11% of the banking system's assets should be in institutions compliant with Islamic law by 2004.

In the Middle East, particularly the Gulf, the growth is being fuelled by the increased amount of money now staying in the region. More of this is finding its way into Islamic institutions as they become increasingly sophisticated and competitive.

This large and growing pool of money provides an opportunity for corporates to diversify funding bases and possibly lower their financing costs. Of course corporates engaged in activities that are not halal (permitted by Islamic law) need not apply, but those willing to try Shariah-compliant structures are likely to be warmly welcomed. Even companies from the non-Islamic world should take note.

Airlines are a good example. Aircraft financing is a highly specialized area dominated by a few banks globally. But the use of Islamic leasing structures has started to gain popularity and is attracting new arrangers. Emirates Airline and Pakistan International Airlines (PIA) have both recently completed Islamic aircraft leasing deals, based on the ijarah structure, to diversify their funding at attractive rates.

Emirates completed two such deals within a fortnight in July. On July 13, the Dubai-based carrier signed a $90 million 12-year Islamic operating lease to acquire an Airbus A330. It was arranged by HSBC Amanah Finance and Dubai Islamic Bank.

The airline then completed a $90 million dual-currency Islamic lease for an A330-200 financed solely by the IDB. The 12-year Islamic operating lease was denominated mainly in sterling with the remainder in US dollars, and was also arranged by HSBC. Emirates has raised over $500 million from Islamic investors over the past three years.

In May, PIA executed a complex three-year receivables-backed Islamic sale-and-leaseback transaction to finance the acquisition of three new Boeing 777s. The $150 million deal, arranged by Citigroup, the IDB and Pakistan-based United Bank, involved the sale and leaseback of a pool of existing aircraft backed by receivables from the UK and Saudi Arabia. The deal attracted the participation of one other Pakistani bank and 10 from the Gulf, with firm commitments of $196 million.

"There is no real difference between the way an ijarah and a conventional lease works," says Saad Ashraf, head of Citigroup's Islamic finance unit. "We pitched against large conventional banks for the mandate."

According to Ashraf, the Middle East is the natural market for many Pakistani and Indian companies because they have better name recognition in the region. "If you're going to target the Middle East market you may as well go the Islamic route because now as much as 15% to 20% of the liquidity is Islamic and conventional investors are just as happy," says Ashraf. He says that "40% to 50% of the deal was taken by conventional institutions in the region".

The growing interest of Islamic investors in aviation assets has not escaped mainstream players. "We haven't originated any Islamic deals ourselves yet, but we have looked at a number of deals and structures and are interested in participating in some Islamic financings in the near future." says Ray Sisson, regional manager for the Middle East, Africa, and CIS, at General Electric Capital Aviation Services (Gecas).

The Middle East is an increasingly important market for the aviation industry, since regional carriers such as Emirates are expanding their fleets. That airline now has total orders of $26 billion.

Recognizing the region's growing importance, Gecas set up a new regional office in Dubai this June. According to Sisson, it isn't just regional airlines that are interested in Islamic finance deals. "A number of western carriers are looking at doing Islamic finance deals too," he says. "It's a chance for them to diversify their funding sources as well."

Shariah-compliant investors' interest in aviation assets is driven by potential returns as well as by suitability for Islamic deal structuring. In the past, certain Islamic investors have declined to touch airline stocks because carriers serve alcohol.

But more recently, at least two aircraft funds have been set up by Islamic finance institutions. In February, Bahrain-based First Islamic Investment Bank, in a joint venture with Montrose, a Bank of America affiliate, bought an ijarah lease interest in a 21-aircraft portfolio for $143 million. "We believe it is a good time to invest in aircraft," says Atif Abdulmalik, CEO of First Islamic. "Prices are near the trough of the cycle so we believe we can get an attractive blended internal rate of return over a five-year period." The portfolio consists of a variety of aircraft on lease to British Airways, Air Canada, and Brit Air and was bought using leverage from an ijarah-based financing facility of $85 million provided by Arab Banking Corporation, CIT group, and Natexis Banques Populaire.