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Can Indonesia be the next Malaysia?

As South East Asia’s largest economy with the world’s largest Muslim population, Indonesia should be well placed to have a burgeoning Islamic finance sector. But instead, Indonesia lags way behind Malaysia on this front. Add to this Indonesia’s lack of infrastructure, and the economy is hardly running at full capacity.

Indonesia is lacking infrastructure. But the government is taking action with a pledge to spend over $200 billion to upgrade and expand infrastructure between 2010 and 2014. And it’s about time for some action. S&P paints a bleak picture of Indonesiaas it stands:

"The country lags its regional peers in efficiency and productivity, mostly because of the poor state of its roads, airports, ports, and other economic lifelines. The poor connectivity across the archipelago is adding to the cost of doing business in the country. Meanwhile, Indonesia is at risk of deeper power shortages over the next few years as demand intensifies. The country's operating reserve margin--calculated as the difference between net dependable capacity and peak demand as a percentage of peak demand--has been reducing over the past five years. In the absence of new generation capacity, the margin could turn negative in the next three to five years--indicating a significant shortfall."

But a recent report by S&P asks a pertinent question: Where will this money come from?

"The government is mulling over various financing alternatives to meet the rest. We believe accelerating the pace of the development of Islamic finance in the country could prove a viable option."
Moreover, infrastructure and Islamic finance complement one another:

Involvement of infrastructure development would generate shariah-compliant assets that can be offered to Islamic investors. These assets are true to the premise of Islamic financing--i.e., to channel funds for the greater good of society. But they would also provide stable, long-term investment for investors. What's more, it helps the government to fill the gap in infrastructure development financing that it doesn't plan to cover through state budgets.”

Recent restrictions on foreign ownership in the banking sector may put off some from investing in Indonesian infrastructure. Pushing forward sukuks, and deepening capital market activity, more generally, would help to bridge the funding gap. By following this path, S&P reckons Indonesia can follow in Malaysia’s footsteps. In Malaysia, during the government's ninth and tenth economic blueprints, sukuks for infrastructure-related activities helped develop transport and improved the service quality of power, water, and gas utilities. Not only did Islamic finance help develop infrastructure, but the alternative financial system has taken off so much that Malaysia is pretty much the world’s first Islamic finance hub. But why is Indonesia so behind? Indonesia is South East Asia’s largest economy and nearly 95% of its 200 million people identify themselves as Muslim. Indonesia, not Malaysia, has the natural ecosystem needed to nurture and develop a strong Islamic finance market. But organic growth can only get you so far. Unlike Indonesia, Malaysia has all the right ingredients in all the right amounts. As S&P highlights:

"We believe three key factors helped Malaysia to develop a large and deep sukuk market. First, there was political will - i.e., the government's willingness to support the establishment of the market. Second, the Malaysian system recognizes the concept of beneficial ownership, which is important in terms of transaction efficiency and costs. Finally, various tax incentives made Islamic finance an economically cheaper alternative for institutions to raise capital."

In 2011 the total value of sukuk issued globally in amounted to $92 billion, a 68% increase on the previous year. Malaysia accounted for 73% - $67 billion - of this. Government-led initiatives in Malaysia have spurred on Islamic finance and encouraged the growth of the sukuk market. While Malaysia realized that organic growth is not enough to develop Islamic finance alone, Indonesia has fallen behind.

S&P has summed up a manifesto for a Malaysian-inspired Islamic finance revolution in Indonesia, which seems to make a lot of sense.


 
 Source: S&P

Policymakers should take note.