Islamic finance, a force in its own right

Islamic finance has come a long way since its beginnings more than 30 years ago. Islamic assets under management, while still a fraction of total banking assets, have grown to nearly US$1 trillion. Moving forward, many of the opportunities lie in project finance Sukuk and Islamic real estate investment trusts as asset-backed financing is at the heart of Islamic finance. Islamic finance has become a force in its own right, especially in the emerging markets of Asia and the Middle East. However, this has not been without its fair share of ups and downs. The industry suffered the after-effects of the global financial crisis and has been criticised for products that look too much like their conventional cousins. It has however, grown to become significant parts of the banking systems in countries such as Saudi Arabia, Malaysia and the United Arab Emirates and even countries with Muslim minorities are considering measures to spur its growth in their markets. To move forward, the industry would do well to go back to its roots. The main principles of Islamic finance are that of risk-sharing: taking on risks for possible rewards or losses and a requirement for financial transactions to be backed by assets such as properties or land. Going back to these principles, especially the latter, will pave the way for what we believe, are the strongest opportunities for Islamic finance: Sukuk (Islamic bonds) project finance and Islamic real estate investment trusts (REITs). Although nascent, there is so much opportunity for more of these deals because project finance bonds and REITs are a natural fit with Islamic finance, which is about building a stable future by investing in the real economy and putting one's capital to productive use for societies' benefit. As the global population is forecasted to reach 9.2 billion by 2050 from 7 billion currently, project finance Sukuk can help to raise more capital to build infrastructures such as roads, water supply installations, houses and schools, especially in developing countries. Islamic REIT, which by definition, is asset-backed by a portfolio of properties, is a new asset class that fund managers and private investors can consider, post the financial crisis, when money has flown out of traditional equities. Project finance Sukuk The population boom means more infrastructure investment will be needed in Africa, Asia and the Gulf Cooperation Council (GCC) countries. Globally, KPMG estimates US$40 trillion is needed in the coming decades to provide basic levels of infrastructure. In the GCC, infrastructure spend is estimated to reach US$120 billion over the next 10 years while Southeast Asia's infrastructure expenditure is forecasted to exceed US$150 billion over the next five years . To fund these projects, governments and private sector developers can use bank financing but the liquidity pool is becoming limited as banks become concerned about liquidity risk and regulations that require more capital to be set aside for long-tenor project finance facilities. Long-tenor financing is essential as infrastructure assets can be productive for at least 10 years. A viable alternative is to tap into the funds of longer-term investors such as pension and sovereign wealth funds, via project finance Sukuk. Given that most of the needs are in the GCC and Southeast Asia, two regions with significant Islamic funds, project finance Sukuk is an avenue that issuers can consider. Investors stand to get long-term steady returns and if the project faces difficulties in meeting its obligations to the Sukuk holders, investors have recourse to the project asset and can step in to take control of the company. In 2010, a significant Sukuk project finance, which was a first in many ways, is Trans Thai-Malaysia (Thailand)'s MYR 600 million Sukuk. The issuer, TTM (Thailand), is equally owned by Thailand and Malaysia's national oil companies, PTT Public Co Ltd and Petronas respectively. The Sukuk is the first project finance bond transaction in Malaysia since 2008 and the first cross-border project bonds in Asia structured in a Shariah-compliant manner. This transaction is likely to pave the way for more governments and companies to use Sukuk project financing to fund their infrastructure projects. Islamic REITs The second opportunity in Islamic finance is REITs. For fund managers and private investors, this asset class is a good alternative to bonds because investors get exposure to real estate while enjoying the benefits of investing in bonds and equities. With REITs, investors get a steady stream of income, which together with potential increase in the share price, may lead to attractive total returns. Share prices tend to be stable. Buyers are available if investors want to sell because listed REITs are liquid. Tax treatment is also favourable because dividends are tax-exempt in some countries like Singapore. The properties and shares are managed by professionals. And investors need far less capital to invest in REITs compared to properties directly. As the diagram shows, most of the listed REITs are currently in the US. Asia, which forms about 12% of the global REIT market, presents an incredible opportunity, especially since REITs have proven to perform better than equity and bond indices in the US and Singapore. In Singapore, total return for the Singapore REIT index is 165%, since the first REIT listed in 2002. This compares to 136% for the Straits Times index, the benchmark for the Singapore stock market, and 46% for 10-year Singapore government bonds over the same period. There is immense opportunity for Islamic REITs specifically, which is very nascent. The five currently listed are mostly in Asia, three in Malaysia and one in Singapore. HSBC was instrumental in the listing of Sabana REIT, the one in Singapore, in November 2010. HSBC Amanah, its global Islamic financial business arm, structured an innovative financing and profit rate hedge that cuts down the number of commodity trades needed from three to one. This meant less documentation, lower costs and a simpler transaction for the customer. This innovative structure can be applied to future Islamic REITs for the customers' benefit. With deals such as TTM Sukuk and Sabana REIT, the industry is definitely moving in the right direction. To continue moving forward, we need all participants, from regulators to scholars, Islamic financial institutions and customers, to come together so more of these deals can be brought to the market. .............................. (Mukhtar Hussain Global CEO of HSBC Amanah and CEO of HSBC Bank Malaysia Berhad, made the comments in an interview published in Euromoney magazine)