MIF Monthly - Malaysia: The International Islamic Financial Center

Amid the bleak outlook for most of the leading global capital markets over the next few quarters, the pulse remains strong for emerging markets, particularly in the GCC and Malaysia. The prospect of sustained growth is positively cautious with an expected proportionate tapering off from the global spillover effect.

To a large extent, growth momentum in the Muslim-predominant financial centers has been driven by not only petrodollars but also the strong initiatives and substantive investments of the respective market regulators, supported by receptiveness and pioneering efforts by home market players to spearhead cutting edge Shariah compliant financial solutions to fund the economic needs of the respective nations.

In terms of both breadth and depth, Sukuk structures have demonstrated widespread market acceptance and progressively evolved into more complex forms. Starting with simple contracts of exchange structures in the 1990s, the market has since seen a higher level of sophistication where Sukuk issuers are concerned with the emergence of a variety of groundbreaking transactions.

This is primarily driven by demand from various issuers for innovative structures to cater to their specific commercial requirements, corporate structure and operational needs, and also increasing investors’ demand for Shariah compliant products that offer attractive rate of returns, as well as the convergence and consolidation of Shariah standards.

The future direction of the Islamic financing market leans toward a greater level of innovation, both in terms of products and the delivery channel. Nevertheless, innovation is also subject to similar parameters to be adhered to by product developers and the market in general.

Apart from investment banks which originate and orchestrate the process, there are five other main stakeholders in Islamic capital market transactions with their respective concerns and aspirations, of which the key issues are summarized below.

Contrary to general expectations, the divergent interests of the five parties do not stifle but instead provides motivation for even more innovation. The challenge of successfully navigating through the myriad of incongruent requirements by stakeholders is not without rewards.

Looking at the Malaysian market specifically, as at the first half of 2008, Sukuk constituted approximately RM210 billion (US$62 billion), or one-third of the total outstanding debt securities in Malaysia (including government issues) — signifying that there is still ample room for improvement in Sukuk’s share of the domestic debt securities market.

As an active player in the Malaysian Sukuk market, OCBC Bank (Malaysia) (OCBC) is committed to supporting the market’s efforts in further developing and strengthening the Sukuk market, not only in Malaysia but also taking additional steps to expand the product reach across our regional network.

In formulating strategies for refining the developmental blueprint of the Sukuk market, it may be useful to draw reference to three of the four basic marketing principles (or the four “Ps”) conceived by renowned strategic marketer, Philip Kotler. These are product, price and place (the fourth is “promotion”).

Product
To assist in analyzing the key product area where Sukuk structures have successfully been adopted, where further refinement/innovation may be possible and potential areas of concern, we shall focus on the following three major product ranges:
1. Asset backed securities (ABS or securitization);
2. Project finance; and
3. Direct corporate credit issues.

• ABS
The current fiasco plaguing the developed securities market may provide significant learning points that Sukuk players can draw upon to re-examine the current product lines. In a nutshell, the ABS bubble crash can be primarily attributed to the questionable quality of underlying assets utilized to create scores of the ABS issues, residential mortgage backed securities, collateralized debt obligations and so on.

However, the fundamental principles of securitization are not without their merits. Briefly tracing its roots, securitization is a financing technique developed in the US with the pioneering mortgage backed securities (MBS) issued in the early 1970s. Over time, the rudimentary principle has evolved and expanded globally through the efforts of various countries to advance the respective financial market frontiers.

In line with the principles of stratifying and allocating risk profile corresponding to the return expectations of investors, ABS methodology has emerged as an effective means to address the often divergent needs of issuers and investors. Securitization facilitates the separation of different risk-and-reward expectations, widens the investor base, and allows credit to be more efficiently priced and allocated to a greater range of investors.

Essentially, one of the key foundations to any securitization exercise is the legal isolation of other creditors’ claims on the securitized assets, thus giving ABS investors a superior claim on the said assets. Theoretically, this will afford a higher degree of protection to ABS investors but, unfortunately, for a lot of investors recently, due to unsound asset selection criteria practiced by major players, the ring-fenced assets, which are mainly financial claims of the originators’ receivables, proved to be worthless under the acid test scenario now unfolding.

For Sukuk securitization process on the other hand, several fundamental requirements need to be fulfilled before the Shariah endorsement can be obtained. Among others is the nature of assets to be securitized and, naturally, only tangible economically viable assets qualify for Sukuk issuance.

Provided the Shariah dictates are adhered to, the technically sound ABS methodology can be adopted for the structuring of Sukuk. The beneficial symbiotic integration which can be forged between Islamic finance and western principles of the securitization concept can be illustrated by referring to the securitization of plantation assets that OCBC pioneered for Midas Plantation (Midas) in 2005 vide the application of future cashflow securitization from the oil palm plantations interlaced with the Islamic asset-based financing structure of Ijarah.

The effect was a significant improvement in the issuer’s credit profile, garnering a tiered rating up to ‘AAA’, which pierced the inherent “industry rating ceiling”. This was made possible from the combined benefits of securitization fundamentals, coupled with structural enhancement vide the Sukuk Ijarah principles which conferred on investors undivided ownership of the tangible assets utilized in the transaction. This provided the investors with dual protection from the ringfencing of the future cashflow streams coupled with a direct recourse to the collateralized assets.

The Islamic plantation securitization structure has proven workable and advantageous to issuers in this asset class, resulting in the structure being replicated for six other oil palm plantation companies in Malaysia. This proved its popularity as a conduit for financing for oil palm plantation companies and investors’ confidence in the sound economic fundamentals and robustness of the structure.

The securitization structure based on Ijarah pioneered by OCBC is quite versatile and can be effectively applied to other asset classes that meet at least the following key criteria:
(i) Stable recurring income-generating capabilities;
(ii) Transferable asset ownership and legally ‘isolatable’ from the originator;
(iii) Transparent and established benchmark for future cashflow valuation.

• Project finance structures
The influx of petrodollar liquidity, especially in the GCC and Middle East and North Africa markets, will help spur more Sukuk issuances for a multitude of projects. Sukuk structures have been well applied in this arena. However, for greenfield project financing through the Sukuk route, it is noted that a number of issues to date are confined to mostly mega projects with strong sponsors or the government concession types.

In contrast, Islamic banks’ bilateral/syndicated financing for greenfield projects is centered more on relatively smaller projects or as a bridger pending refinancing through a longer-term Sukuk issue. This arrangement, usually with recourse to the sponsor, is undertaken to mitigate the negative rating impact from pre-completion risk elements.

For developing economies such as those under the Organization of The Islamic Conference, with the evolution of project financing structures toward more distinct PFI models, the Sukuk market needs to gear up to take the challenge in funding these projects — where there will be less direct governmental support and the project cashflow will be subject to a higher degree of market and commercial risk.

Sukuk players would be required to engineer more sophisticated structures to cater for the new dynamics and it is foreseeable that greater emphasis will be placed on purer forms of profit- and risk-sharing structures.

However, as the current crop of domestic Sukuk investors are mainly institutional (Islamic or otherwise) fixed income investors, more efforts may be required to create or develop a new category of hybrid debt/equity investors to enable continued smooth progression in this area.

The “true-blue” Mudarabah/Musharakah structures advocated by Shariah scholars theoretically may be more suited to the domain of equity investors.

However, as the present regulations governing Sukuk in Malaysia classify these instruments as debenture, it still remains under the purview of fixed income investors. Hence, there may be a fundamental mismatch that needs to be addressed through both private and public sector combined initiatives.

• Corporate credit-based structures
With the pronouncement by the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) in February 2008 on the prohibition of “purchase undertaking” for Mudarabah, Musharakah and Wakalah structures, it is envisaged that there will be a gradual shift toward more non-recourse structures. Arising from the absence of overt capital protection, Sukuk advisers or arrangers will be compelled to come up with even more innovative structures, under which the investors are afforded a certain degree of acceptable form of protection to ensure that these Sukuk issuers are not burdened with higher pricing due to perceived higher risk profile.

The securitization structures discussed earlier are principally asset backed transactions. Nevertheless, several viable corporations are asset-light, with unsuitable assets for the purpose of securitization or corporate structure restrictions but with strong business prospects in need of Shariah compliant financing.

As one of the feasible solutions to businesses in this situation, OCBC pioneered a Mudarabah structure for general corporate funding without recourse to any purchase undertaking from the obligor. In the case of Muhibbah Engineering’s (ME) RM400 million (US$118.3 million) Sukuk Mudarabah launched in April 2008, the financing provided was Mudarabah Mutlaqah (unrestricted entrepreneurial discretion) geared for the issuer’s general business purposes, and not earmarked against any particular business ventures or assets of the company.

In this structure, ME acted as the mudarib (or entrepreneur) to manage the issuance proceeds on behalf of the investors in its existing business ventures, with the Sukuk investors providing 100% of the Mudarabah investment capital.

The relevant profit-sharing ratio (PSR) and expected profit rate (EPR) are agreed upon between the issuer and the facility agent at each issuance date. Determination of the distributable profits shall be based on the issuer’s consolidated revenue, less attributable costs for the relevant investment period. The returns to investors comprise the actual share of profit based on the PSR or profit payments based on the EPR, whichever is lower.

The mudarib is entitled to the excess profit above the EPR as incentive fees, provided the mutually agreed covenants are duly abided. As with all other Mudarabah structures, in case of genuine business losses, the capital contributor shall solely bear the losses without recourse to the mudarib.

There are several key structural highlights in this transaction. Firstly, while the issuer or mudarib is prohibited from guaranteeing the returns or capital, the investment capital is advanced on trust obligation basis for a specified investment period. Provided the business performs to expectations, the mudarib is obliged to make profit payments and redeem the investment capital on the investment maturity date.

Investor protection is further enhanced via several Shariah neutral features such as negative pledge and governing covenants (financial and commercial) providing early warning measures to enable investors to take timely precautionary measures.

In general, the structure is suitable for brownfield projects or existing businesses with an established and stable track record, positive industry outlook but restricted/minimal tangible asset base.

The Mudarabah structure on Mutlaqah basis is suitable for most type of corporations with decent operating cashflow, a clean balance sheet and is also highly flexible in terms of usage of the financing proceeds, provided the utilization does not contradict the Shariah. A typical application may include the company’s general working capital and/or short-mid-term expansion program.

Price
Similar to traditional bonds, the profit rate determination of Sukuk is a two-component item comprising the prevailing benchmark rates and issuer’s credit rating. Pricing of Sukuk is a delicate balancing act between the floor pricing demanded by issuers and the perceived credit risk premium expectations of the Sukuk investors.

In Malaysia, the prevailing ample market liquidity and the regulator’s facilitative stance have afforded a conducive domestic pricing environment in spite of the ad-hoc spikes now and then.

To help gauge the pricing effectiveness of the domestic debt capital market in general, the following illustration on market liquidity vis-à-vis credit rating and pricing may serve as a useful guide.

Although credit risk can be appropriately priced, it can be seen that there’s currently a wide gap of “evaporated” liquidity for the lower rated papers, which if not properly addressed may be a stifling if not crippling factor in the healthy development of the market in the long run. Current statistics show that less than 10% of the market, Sukuk or otherwise, are invested in this rating category. The primary reason for this phenomenon may be partially attributed to the investment mandate/institutional policies of most fixed income investors which generally restrict or limit the investment in the single ‘A’ rated papers.

While it is an acknowledged fact that institutional investors are operating on prudent investment guidelines designed to protect the public monies entrusted to them, an opportunity exists for the establishment of an appropriate class of investor base to spur this market segment further.

Place
For Malaysia, the domestic market is nearing the matured stage and, with it, the industry is now heavily gearing up to expand its horizons to new frontiers in the regional and international arenas. In the world of intertwining trade and investment flows, increasing sophistication and fluid dynamics, to sustain a healthy long-term growth of the domestic capital market, it is imperative for the market players to be adequately aware of and equipped with the latest tools and skill sets to fully embrace the many challenges of the global platform.

To have a better sense of the market environment on an international scale, market liquidity vis-à-vis credit rating and pricing landscape as illustrated below may provide us with a broad overview to gauge our current positioning.

From the diagram below, it can be clearly seen that for the majority of relatively good domestic credits, the international capital market is mostly out of reach. One of the main reasons for this situation is the “sovereign rating ceiling” factor, which practically caps the domestic issuers’ rating prospect on the global arena.

To bridge this present handicap, on a personal view basis, there may a valid case for the relevant stakeholders to explore the potential for a cross-border rating class which may be adopted for jurisdictions that intend to promote bilateral investment flows. This may establish the required foundation for deal structurers to work from, and assist issuers and investors in the respective markets to have not only a credible benchmark for pricing the cross-border Sukuk issues but also enable better appreciation of each other’s market environment, which may also further boost intra-regional economic activities.

Learn from recent events
With the psychological threshold of US$100 billion within reach, the Sukuk market is set to gain more momentum and develop critical mass on its road to achieving a sizeable level (i.e. above 1%) of market share vis-à-vis the global bond market within the next decade. Steadfast innovation on products, refinement on price and delivery channels (encompassing place and promotion) will continue to be the way forward.

In charting the future direction for the Sukuk market, it may also be good for market players to reflect on the lessons learnt from recent events in the global financial markets. While there’s no guarantee that Sukuk issues may totally avoid distress from inferior credits, further strengthening of the Shariah framework will also provide another layer of prudential review for Sukuk structures.

With additional efforts on product research and development, improving market efficiency and intra-regional collaboration while concurrently being in compliance with international Shariah standards, Islamic finance products and delivery channel quality will continue to improve at a greater level and be in the forefront of world-class avant-garde financing structures development.

This article was written by Alhami Mohd Abdan (alhami@ocbc.com) and Azlan Firman Abd Karim (azlanfirman@ocbc.com), who are head of Islamic finance and manager of investment banking, respectively.