Islamic finance moves into the mainstream

Financial engineering for ethical investors

Islamic finance is slowly proving that it is competitive with the mainstream sector. In Malaysia, issuance of Islamic private debt securities has risen from 1.1% of the local debt market in 1992 to 42% in 2001. Companies controlled by non-Muslims account for about 30% of the volume of Islamic private-debt securities issued in Malaysia. Many of the largest domestic debt issuers use Islamic structures because they give them access to the liquidity of large Islamic institutional investors, such as Tabung Haji, the pilgrimage savers’ fund, in addition to that of conventional investors.

In Saudi Arabia anecdotal evidence suggests that in the domestic market more new money is flowing into Islamic products than into conventional ones. The Islamic banking operations of one Saudi bank, National Commercial Bank, look set to eclipse its parent.

Opportunities in Islamic finance are not confined to markets with large Muslim populations such as the Middle East, Malaysia, Indonesia, and Pakistan. Non-Muslim issuers from outside these countries can use Islamic finance structures to help unlock and channel the underexploited pool of liquidity controlled by Muslim investors. The size of this untapped reserve is anyone’s guess but figures around the one trillion dollar mark are frequently bandied about.

Citigroup’s Islamic finance business has been particularly successful in helping issuers from non-Muslim countries tap this investor base, which tends to buy and hold, and to be a bit less price sensitive because of a lack of investment opportunities. Citigroup has worked on Islamic finance deals for issuers as varied as South Korean companies Daewoo, Samsung, and Hyundai; Hungarian oil company Mol; Brazil’s Petroleo Brasileiro, Absa of South Africa; Tate&Lyle of the UK; and Slovnaft of Slovakia.

In future more issuers may wish to diversify their investor base to the Middle East by including Islamic structured tranches in their bond deals.

Mainstream finance professionals tend to find the prohibition on interest charges and payments in Islamic finance hard to comprehend. But the fact that Islamic finance structures charge fixed profit margins that do not compound, instead of interest, is actually attractive to many corporates seeking project finance type deals. Using these structures will not necessarily result in a lower cost of funding, because the profit margin tends to be calculated around the prevailing relevant interest rate, but it does make financial planning simpler for corporates, especially for long-term transactions.

Interest from corporates Korean conglomerate Hyundai is a good example of a mainstream corporate from outside the Muslim world that has taken advantage of Islamic transactions to diversify its funding and investor base. Hyundai’s UK-based trading arm did three Islamic trade finance deals in 1999, arranged by Citigroup around the murabaha contract, to finance oil and gas imports from the Middle East. These deals raised a total of $125 million and were of maturities of six months and one year.

Citigroup also helped US construction group Bechtel to finance a motorway construction project in Turkey in 2001 through a three-year $45 million project financing facility based on the istina contract. The Turkish government guaranteed the financing but it was up to Bechtel to arrange it. The deal was one of the first of its kind. “There is an educational aspect to most of our origination work,” says Saad Ashraf, unit head of global Islamic finance at Citigroup in London. “We have to explain these structures to unfamiliar issuers, but generally these issuers who use Islamic finance do so because they see it as a means to diversify their funding sources, which is beneficial from a rating agency perspective.”

In December 2002 PLDT, the Philippines’ largest telecoms group announced its first Islamic financing deal. The landmark five-year, $50 million Ijarah on future receivables attracted wide-spread participation from Middle East banks.

Typical investors in these deals are financial institutions based in the Middle East but not just Islamic ones. Mainstream banks throughout the region are familiar with Islamic structures and many have large Islamic windows or subsidiaries. Most of the deals are done by private placements – although some are syndicated – which makes the market opaque so that it is hard to accurately compare the costs of funding between Islamic and mainstream structures. But banks in the Middle East, both Islamic and mainstream, are very liquid and have an appetite for Shariah-compliant investment opportunities that is significant and growing faster than the opportunities themselves. This implies potentially attractive funding costs to anyone brave enough to tap it.

Islamic finance will never be suitable for all companies. The prohibition on certain businesses and reluctance to invest in those with a high debt to market capitalization ratio means that some- including conventional banks – will never have the option.

Islamic deals also tend to take longer than conventional ones and can be slightly more expensive to structure because of the extra due diligence aspects and need to get Shariah board approval. But according to Iqbal Khan, CEO of HSBC Amanah Finance, this problem is decreasing. “The lead times are longer, and this adds to the cost,” he says, “but these times are getting shorter as each new deal gets done.”