Can Islamic finance bridge Asia’s infrastructure deficit?

Author: Thiam Hee Ng, ADB

The global Islamic debt securities (sukuk) market has grown rapidly, from just US$15 billion in 2001 to US$281 billion in 2013. This increase has been led by Malaysia, which accounts for nearly 60 per cent of total outstanding sukuk. Meanwhile, Middle Eastern countries account for about 30 per cent. Sukuk bonds still only represent a small portion of Asia’s overall bond market, but there is great potential for the sukuk market to grow and play a key role in helping to finance the region’s large infrastructure requirements.

Bank financing for long-term infrastructure projects is becoming less attractive under the Basel III rules. Hence the burden for financing infrastructure is expected to shift away from banks toward bond markets, which can help tap long-term institutional investors such as pension funds and insurance companies. Infrastructure projects that build tangible assets that generate revenues are consistent with the Islamic finance stricture of creating economic value; such projects are therefore appropriate for sukuk.

While sukuk bonds have successfully been used to finance large-scale infrastructure projects in Malaysia, they have failed to take off outside the country. This is because other economies are yet to develop a stable regulatory framework and economic environment. Their capital markets are also relatively underdeveloped, hindering the ability of infrastructure projects to raise funds.

Another impediment is the lack of consistency in shari’ah guidelines for structuring Islamic financing for infrastructure projects. There are different guidelines for different markets and even for different Islamic financial institutions. Hence, there is a lack of certainty that a financing structure acceptable to one Islamic institution will prove acceptable to other Islamic institutions, particularly those from different jurisdictions.

The development of a consistent Islamic financing framework that can be applied throughout the region would help in promoting greater acceptance of sukuk among investors. A standard model of Islamic infrastructure financing could jumpstart the Islamic bond market for infrastructure and broaden its appeal. Finally, there may be capacity constraints among Islamic financial institutions to undertake the complex task of structuring infrastructure projects. But the more projects that go ahead, the more experience institutions will gain.

Authorities can jumpstart the sukuk market by issuing large quantities of bonds. A sizeable pool of sovereign sukuk would serve as a signal to the corporate sector to become involved in sukuk. And it’s not just the central government: municipal and government agencies can also help promote the growth of the sukuk market by sourcing part of their borrowing requirements from the Islamic market.

So far, most sukuk have been issued under either the murabahah (cost-plus or deferred payment) or ijarah (lease-based) structures. These structures are popular because they are similar to conventional bonds in the sense that they offer certainty of returns. However, there is great potential to develop profit-sharing sukuk structures — such as musharakah (joint-venture) where both investor and issuer agree to share profits and losses resulting from the performance of the underlying infrastructure projects. As yet, these represent only a small proportion of the sukuk market. However, they are seen as a more desirable structure for financing from an Islamic perspective because they share risk and reward between issuers and investors.

Since there is no fixed claim on cashflow from projects, the musharakah structure can help reduce risk for issuers in financing infrastructure projects. This is particularly important for infrastructure projects where revenue flows may be volatile and uncertain. By sharing risks with issuers and reducing their debt-servicing obligations during difficult periods, sukuk investors can reduce the risk of default. In return for bearing the extra risk, investors gain a higher rate of return.

Governments must ensure that sukuk are not treated unfavourably by tax and regulatory regimes, most of which were not designed with Islamic products in mind. Islamic financial products tend to be at a disadvantage compared with conventional financial instruments. For example, there may be unequal treatment in the tax systems of some countries between profit and interest payments. While interest payments are generally tax-deductible, profits are taxable. As a result, profit-sharing sukuk may be less attractive to investors. These and similar issues must be addressed.

If these constraints are addressed there is potential for sukuk to be a viable supplement to conventional bonds for infrastructure financing. By helping issuers reach out to the large pool of funds seeking shari’ah-compliant investments, it could help to lower the financing cost of infrastructure projects in the region. The innovative profit-sharing structures of some sukuk could also help reduce the risk of financing infrastructure projects.

Thiam Hee Ng is Senior Economist at the Asian Development Bank.

Why Beijing shouldn’t worry about Manila’s military upgrades

Author: Joseph Franco, RSIS

On 28 March 2014 Manila signed a US$420 million contract for the delivery of 12 Korean Aerospace Industries FA-50 aircraft for light surface attack and lead-in fighter roles. The purchase marked the return of the Philippine air force to the jet age. So far, it is the highest point in the Philippines’ gradual build-up of a ‘minimum credible defence posture’, and a recapitalisation of Southeast Asia’s least-capable military with the support of the US.

The upgrade can be easily cast as Manila’s response to the increasing assertiveness of China over its territorial claims in the South China Sea (known as the West Philippine Sea in the Philippines). Currently, the most likely flashpoint has shifted to Ayungin Shoal following China’s demand that the Philippines remove a beached Filipino warship that it has converted into an outpost. Tensions between Manila and Beijing reached a tipping point in 2012 with a standoff in Scarborough Shoal when the Philippine Navy’s frigate BRP Gregorio Del Pilar attempted to expel Chinese fishing boats. The incident was framed by Beijing as a disproportionate use of the Philippine military, leading to China’s de facto control over the shoal.

Compared to the Philippines’ 2007 Capability Upgrade Program, which focused on basic move-shoot-communicate assets (such as handheld radios, body armour, troop carriers), recent acquisitions have a clear external defence orientation. This explains the focus on offshore patrol vessels (OPV) and aircraft purchases.

The reorientation is made possible by the winding down of internal security threats, which have preoccupied the Armed Forces of the Philippines (AFP) over the last 12 years. Recent developments such as the signing of a peace agreement with the largest Muslim secessionist group in Mindanao, and the arrest of the top leadership of the communist insurgent movement, have highlighted the improved internal security situation. The current AFP counterinsurgency strategy calls for a phased transition to external defence that is to be completed by 2016.

Yet Manila’s shopping list remains limited by fiscal constraints. The two Del Pilar-class vessels, while adequate for Exclusive Economic Zone and offshore patrol vessel-type duties, carry similarly limited armaments to the Jacinto-class OPVs. The Jacintos prior to the Del Pilar, were then the PN’s most blue ocean-capable ships.  The Del Pilar’s capability to conduct helicopter flight operations and stay on station longer is the only incremental improvement it has over the Jacintos. The addition of expensive systems such as anti-ship missiles and anti-submarine warfare equipment is highly contingent on additional funding.Concerns have been raised over whether supplemental funding for the AFP will continue after the end of President Aquino’s term in 2016. Aquino has a keen personal interest in military equipment and has thus provided an important impetus for greater defence resource allocation. A less enthusisatic President could translate into decreased defence spending and derail AFP modernisation.

The AFP also appears to want to diversify the capabilities of its prospective assets. It has sought to cast equipment acquisitions such as the AW109 PN Multipurpose Helicopter purchase, the Bell 412 Combat Utility Helicopter, and the Strategic Sealift Vessel as multi-use platforms.

As was demonstrated by the long lead-up to the signing of the FA-50 contract, there is more political resistance to equipment acquisitions that are primarily framed for warfighting. The apparent preference for multi-role assets is also understandable given the myriad of non-hostile military operations undertaken by the AFP such as disaster relief. But it must be stressed that such tasks act as a distraction from fully transitoning the AFP to external defence. Military involvement in duties other than warfighting are  are symptomatic of the Philippines’ overall lack of civilian civil defence capability, specifically disaster search and rescue, and relief operations.

Given the fiscal and political context of the Philippines’ military modernisation, China’s concerns over the purported destabilising effect of Philippine modernisation appear to be unwarranted. While it is true that the purchases will likely complicate any expansionist move by Beijing, Manila’s purchases have remained consistent with its goal of obtaining a ‘minimal credible defence posture’. Territorial claims are best enforced through less belligerent acts, and having a presence in contested waters is still more important than sheer offensive capability. The Philippine government seems to have learnt its lesson from China’s de facto occupation of Scarborough and will seek to deny Beijing a pretext to take over Ayungin Shoal.

Manila could leverage a heavy-handed Chinese response, even by non-military assets, to its advantage. On 30 March 2014, a resupply mission to Ayungin Shoal—fully covered by the media—was used to underscore the narrative of a seemingly David and Goliath struggle between Manila and Beijing. But aside from a concerted PR push, Manila has also been pushing at the diplomatic front. In short, Manila seemed to have recognised the asymmetrical options it has at its disposal.

For now, as paradoxical as it may sound, the combination of a more cautious, albeit still assertive China, and a more credible Philippines may allow tensions in the South China Sea to simmer down. 

Joseph Franco is an Associate Research Fellow from the S Rajaratnam School of International Studies, Nanyang Technological University, Singapore.

Is the glass half full or half empty in Malaysia?

Author: Nurhisham Hussein, Malaysia

There is a stark divide between perception and reality when it comes to the Malaysian economy. According to official statistics, the Malaysian economy grew 4.7 per cent in 2013, down from the 5.6 per cent recorded in 2012.

Despite the lower number, GDP growth throughout 2013 accelerated, rising from 4.1 per cent in the first quarter to 5.1 per cent in the last quarter.

These are by no means bad growth figures. Given the slowing increase in the labour force over the past few decades, Malaysia’s potential for economic growth has been naturally declining. A growth rate averaging above 5 per cent for the last two years is in fact commendable, especially since Malaysia’s neighbours are doing considerably worse, relatively speaking.

But there remains a startling pessimism regarding the state of the Malaysian economy, a pessimism that transcends concerns over the cost of living, unemployment or income growth. This seems hard to account for. The economy has grown, and grown in a fairly robust manner. Real GDP growth in South Korea, Taiwan, Thailand and Hong Kong all averaged or exceeded 4 per cent between 2001 and 2010 with Singapore averaging above 5.5 per cent; Malaysia meanwhile saw growth around 4.6 per cent. Since then, average growth for the above economies was 2.9 per cent, 2.5 per cent, 3.2 per cent, 3.1 per cent, and 3.3 per cent, respectively. Malaysia by contrast averaged over 5 per cent during this time.

After the initial recovery from the global recession of 2008–09, global trade growth levelled off. Countries that were most dependent on global trade saw their economic expansion slowed. Yet in the Malaysian case that barely occurred, despite being one of the most highly exposed and open economies in the world. What explains this gravity-defying performance?

Whatever one might think of the virtues or faults of the government’s Economic Transformation Programme (ETP), it deserves the credit for Malaysia’s buoyancy. By fostering an environment conducive to investment, Malaysia saw a sudden sharp increase in capital investment, both public and private. While the infrastructure projects under the ETP hogged the limelight, private investment increased sharply as well, particularly in 2012. There’s no doubt that the resulting investment boom helped support economic growth even as external demand remained subdued.

Yet this apparent success was not broad-based. Growth was primarily concentrated in construction and its related sectors. While one could argue that investment in infrastructure such as the Mass Rapid Transit project was necessary and long overdue, there was also an accompanying boom in commercial property construction. The manufacturing sector, however, suffered from flat exports, while the primary sectors were affected by both slowing demand and softer commodity prices.

So, on the one hand, the benefits of Malaysia’s recent growth have been narrowly distributed while, on the other, risks to the economy are increased from potential over-investment in a single sub-sector.

Not that this is unusual for Malaysia. Growth in the 1990s was focused in manufacturing and construction, with the primary sector declining. Similarly, growth in the 2000s (pre-2008) saw the return of agriculture and mining, outshining growth in both manufacturing and construction as a global commodity price boom helped drive up incomes in those sectors.

The Malaysian economy is thus fairly diversified, with multiple sources of growth. This will help sustain aggregate income growth even when particular sectors are not doing so well. But in turn, it means the distribution of the benefits of that growth can and will be uneven at any given point in time.

Over the last few years, construction and real estate have been significant drivers of growth. With the recovery in the US and other advanced economies now taking root, manufacturing looks set to join the party. But the ongoing growth slowdown in China and India has affected demand and prices for primary commodities, and the outlook for the palm oil and the oil and gas sectors is not strong.

Perceptions of the state of the Malaysian economy therefore really depend on who you’re asking, and when.

Nurhisham Hussein is a Malaysian economist.