| A number of airlines have started to use Islamic finance structures |
THE ISLAMIC DEVELOPMENT Bank (IDB) has the lowest ratio of net development-related assets to shareholders’ equity and the best liquid assets to gross debt ratio of all the multilateral development banks.
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.
Comparable structures “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.
Kuwait Finance House (KFH), a Kuwaiti Islamic bank, has also been active in the aircraft market, establishing a dedicated Islamic investment fund, the Millennium Aircraft Leasing Company.
The halal nature of the airline and aircraft manufacturing industries and the widespread use of leasing finance means that aircraft financing fits comfortably with Islamic finance. The only barrier is in Islamic financial institutions’ industry expertise, but by teaming up with mainstream industry players the field can be opened up.
Aircraft finance is just one example of areas in which Islamic finance could play a larger role globally. And it is just one sector in which corporates worldwide can attract extra liquidity and diversify funding sources with competitively structured and priced transactions.
As long as the industry and company are halal, it should be possible to attract Islamic investors and institutions with a Shariah-compliant structured transaction.
Commodities are another obvious area for Shariah-compliant products. Daewoo, Samsung, Hyundai, Hungarian oil company Mol, Petróleo Brasileiro, Absa, and Tate & Lyle, have all used murabaha contacts to finance commodity imports. The murabaha structure allows a bank to purchase a good for a client, which then makes deferred payments to cover the cost plus an agreed profit margin.
Islamic investments in real estate have traditionally been hampered by the threat of double stamp duty under many jurisdictions. This is because under an ijarah-based mortgage the title changes hands twice, first to the bank and then to the end purchaser. Islamic banks have worked hard to circumvent this and some western regulators, realizing that this unfairly handicaps Muslim property buyers, have worked to make exceptions. In July, the UK Treasury removed the double stamp duty, allowing HSBC to offer a competitive Islamic mortgage in the UK.
Noriba, the Shariah-compliant wealth management subsidiary of UBS, and First Islamic have explored Islamic real-estate investments in Europe. Noriba completed its first UK real-estate transaction this July. The £140 million ($224 million) deal involved the purchase of 1 Trafalgar Square, in London, using an ijarah-based structure. The property was purchased on behalf of Noriba clients who will receive regular rental payments and benefit from any rise in the property’s value when it is sold.
Noriba is so keen to find Shariah-compliant investment opportunities that it is busily approaching potential issuers. “We are approaching governments and corporates with proposed sukuk deals,” says Mohamad Toufic Kanafani, Noriba’s CEO. “What we are proposing is to buy selected assets off them and then lease them back to give our clients new attractive investment opportunities.”
In June BNP Paribas became the latest in a growing list of international banks to set up a dedicated Islamic finance unit following in the footsteps of HSBC, Citigroup, and UBS. Standard Chartered, too, is looking into launching an Islamic finance window in the Middle East to be based in Dubai. BNP has previously worked with Kuwait Finance House on developing short-term Islamic money market bonds, while Standard Chartered carries out some Islamic finance activities in Malaysia.
Middle East money is what attracts most international corporates and banks to Islamic finance but Malaysia arguably remains the centre of innovation, helped by the more advanced and liberal state of its capital markets and, some would say, more liberal Shariah interpretations.
In 2002, issuance of Islamic fixed-income securities exceeded conventional securities for the first time, making up 60% of the total of about M$20 billion ($5.3 billion). A major reason for the strong growth of the Islamic market relative to the conventional one is that Malaysia has sizeable Islamic investors such as Lembaga Tabung Haji, the pilgrims’ fund board, whose participation helps lower prices by as much as 5 to 10 basis points, according to Malaysian investment bank Aseambankers.
The use of Islamic structures is now mainstream for both issuers and investors unmotivated by religious principles. In March, Nestlé Foods Malaysia launched a M$700 million MTN issuance programme based on the al-murabaha structure.
Compatibility problems
Tapping the large and growing Middle East Islamic finance liquidity pool is not that easy, however, as Malaysia’s experience shows. The country has so far failed to attract significant liquidity from Middle Eastern Islamic financial institutions, because they do not recognize the most popular Islamic bond structure used in Malaysia, the al-bai bithaman ajil.
As a result Malaysian banks and corporates are now more keen to explore more widely accepted structures such as the sukuk al-ijarah, a kind of asset-backed security such as that used in the Malaysian sovereign’s pioneering $600 million global in June 2002. This attracted wide participation from both Islamic financial institutions in the Middle East and conventional European investors. Another such deal has been announced for this month.
Malaysian Islamic finance institutions have long worked with counterparts in the Gulf and Pakistan to help develop products in the Gulf. Now Malaysian investment banks are seeking to expand their presence on the ground there to help distribute Malaysian Islamic debt securities and funds. Aseambankers opened an offshore branch in Bahrain in September 2002, and domestic rival Commerce International Merchant Bankers (CIMB) signed a memorandum of understanding with Al Tawfeek Company for Investment Funds, part of the Dallah Al Baraka group of Saudi Arabia.
These moves are important not only to Malaysian institutions eager to attract Middle East liquidity to the domestic capital market but also for Islamic finance as a whole as they should help to harmonize practices. It is also a big test. If Malaysia can entice flows from the Middle East, others could learn from its example.
