Kiddie-Pool Islamic Loan Ending Indonesian Invisibility

BLOOMBERG.COM---Indonesia is counting on people like Nur Hanifah, a 50-year-old widow who sells plastic buckets and inflatable kiddie pools, to help it catch Malaysia, a country one-tenth the size that leads the world in Islamic finance.

Hanifah took out a Shariah-compliant loan from PT Bank Muamalat Indonesia after her husband’s death to help finance a store on the ground floor of a shophouse in Serang, two hours’ drive west of Jakarta. While she doesn’t pay any interest, borrowers like Hanifah typically must give the bank 40 percent of their profit plus part of the principal each month.

“When times are good, I pay more on my loan than most people,” said Hanifah, whose monthly take is about 50 million rupiah ($5,189). “But I won’t have to worry when times are bad. I don’t have to pay anything when I’m not turning a profit.”

Loans like Hanifah’s could help Indonesia, the country with the world’s largest Muslim population, narrow the gap with its neighbor. It’s speeding up government approvals and fixing a fragmented regulatory system as part of an effort to reach more unbanked Muslims and increase the portion of Islamic assets in the banking system to 15 percent by 2017, from 4.3 percent.

That’s creating opportunities for global banks includingStandard Chartered Plc (STAN) and HSBC Holdings Plc (HSBA), both based in London, which are issuing financial products that comply with Islamic law, or Shariah, as fast as regulators allow. It’s also attracting interest from Malaysian lenders across the narrow strait separating the two countries.

Quadrupling Share

“That’s huge growth we’re talking about, quadrupling the market share,” Wasim Saifi, Standard Chartered’s Kuala Lumpur- based global head of Islamic consumer banking, said in an interview in Singapore. “Indonesia is clearly one market where everybody sees the maximum growth potential.”

Indonesia’s central bank and its government approved new products and platforms last year and issued more Shariah- compliant bonds, helping support an industry poised to expand worldwide at almost three times the pace of financial assets.

“Indonesia is only now undergoing wider financial reforms, of which Islamic finance is a part, to tap international capital markets especially from Gulf investors,” Abas A. Jalil, chief executive officer at Amanah Capital Group Ltd., a Kuala Lumpur- based consulting company, said in a Dec. 6 interview. “Bank Indonesia could only recently begin organizing laws for the non- Islamic side, let alone the Islamic, as they were hindered by the government and then the Asian financial crisis.”

Record Sukuk

Southeast Asia’s largest economy sold $1 billion of global Islamic bonds in November, with bids exceeding supply by five times. Buyers in the Middle East accounted for 30 percent of the order book, compared with 23 percent in Asia, 20 percent in Indonesia, 12 percent in the U.S. and 15 percent in Europe, according to Loto Srianita Ginting, director of government securities at the Finance Ministry’s debt-management office.

The government has issued Shariah-compliant sovereign bonds, known as sukuk, at mostly regular, two-week intervals, setting a record of 57.1 trillion rupiah last year compared with 34 trillion rupiah in 2011.

It may offer about 53 trillion rupiah this year, Dahlan Siamat, Islamic financing director at the debt-management office, said by text message today.

Indonesia ranks fifth in the amount of outstanding Islamic bonds, after Malaysia, Saudi Arabia, United Arab Emirates and Qatar, accounting for 4.4 percent of the world’s total, according to a Malaysian central bankreport. Malaysia represents 62 percent of the global sukuk outstanding. As of the end of the first half of 2012, it had $129.4 billion outstanding compared with $9.3 billion for Indonesia.

Interest Ban

The bonds pay returns on assets to comply with Islam’s ban on interest. The government may use public property to back the sukuk by transferring its ownership to creditors until maturity while leasing the asset to make coupon payments.

Indonesia allows 16 Islamic-banking products, compared with 59 in Malaysia, according to the countries’ central banks. Regulators in Indonesia are assessing a 17th, a Shariah- compliant instrument for banks to hedge against currency swings, said Edy Setiadi, executive director of Islamic banking at Bank Indonesia. A similar instrument has been offered since 2006 by lenders in Malaysia, including Standard Chartered, HSBC and CIMB Islamic Bank Bhd.

The global Islamic finance industry is expanding at an average annual rate of 15 percent, according to Malaysia’s Securities Commission. That’s almost three times as fast as the 5.5 percent increase for all financial assets in 2010 cited in a 2011 McKinsey Global Institute report. It will more than double to $2.8 trillion in 2015, from $1.1 trillion in 2011, the Islamic Financial Services Board in Kuala Lumpur estimates.

Realizing Potential

“We are all very anxious to see Indonesia come out and realize its potential,” Rauf Rashid, Malaysia managing partner at Ernst & Young LLP, said in an interview at the Global Islamic Finance Forum in Kuala Lumpur in September. “The market is simply massive, if only the powers that be can align with the business community to tap this opportunity in Islamic finance.”

Islamic banking in Indonesia trails Malaysia by almost a decade. The country’s debut Shariah-compliant lender, Bank Muamalat, opened in 1992. Bank Islam Malaysia Bhd., Malaysia’s first, started in 1983.

One reason for the lag was that Indonesia’s central bank was under the authority of the government from 1968 to 1999, during most of President Suharto’s rule. The country also was hit harder during the Asian financial crisis that began in 1997. Indonesia spent about 57 percent of the value of its gross domestic product to restructure its banks from 1997 to 2001, according to a report by the International Monetary Fund. That compares with the 16 percent of GDP that Malaysia spent to revive its financial system from 1997 through 1999.

Investment Limit

Bank Indonesia didn’t announce rules regulating foreign ownership of local lenders until July, setting a limit of 40 percent for both Islamic and non-Islamic lenders.

Malaysia’s central bank, Bank Negara Malaysia, which has been independent since its establishment in 1959, revised its law seven years ago to allow foreigners to hold a larger portion of Shariah-compliant banks than of conventional lenders to spur Islamic banking. The authority increased the limit to 49 percent in 2005 from 30 percent, and to 70 percent in 2009.

HSBC, the world’s largest underwriter of sukuk for both government and corporate issuances, had a 24 percent global market share totaling $11.1 billion in 2012, according to data compiled by Bloomberg. Three percent of that was in Indonesia. Cheaper borrowing costs spurred Islamic bond offerings to an all-time high of $46.3 billion last year, exceeding the previous record of $36.7 billion for 2011, the data show. Malaysia’s Cagamas Bhd. brought sales so far this year to $41 million.

Breaking Records

Indonesian companies probably will break corporate sukuk records this year after issuing less than 1 percent of Malaysia’s 95 billion ringgit ($31.5 billion) in 2012, according to estimates by PT Danareksa Sekuritas and PT Indo Premier Securities, Indonesia’s top two arrangers.

HSBC, which declined to make an executive available for an interview, said in an Oct. 4 statement that it’s scaling back its global Islamic finance business in less-profitable markets, including the U.K. and Singapore, to concentrate on Malaysia and Saudi Arabia while maintaining a presence in Indonesia.

Islamic lenders in Indonesia including Bank Muamalat, the PT BNI Syariah unit of PT Bank Negara Indonesia and CIMB Islamic, part of Malaysia’s second-largest banking group, have said they want to provide fixed-rate deposits to consumers so they can compete directly with non-Islamic banks. Such accounts have been available in Malaysia since 2007.

Shariah-compliant banks can offer fixed rates on deposits using a contract to sell and repurchase assets with a markup and deferred payments, called murabaha. A bank may offer to sell and repurchase a property with 10 percent markup paid over two years, resulting in stable payments of 5 percent each year.

Sending Thugs

The number of Indonesians using Islamic financial products increased 37 percent over the past year through Nov. 30 compared with a 32 percent rise in the previous period and 19 percent the year before, central bank show. That’s still only 13.8 million people in a country of 208 million Muslims.

Hanifah, the shop owner, is one of them. She said she despaired of making monthly interest payments on a regular bank loan after her husband’s death in an accident in 2004. It took her five years with the help of relatives to repay a debt of 32 million rupiah at a rate of 18 percent without any income.

This time it’s different.

“When I didn’t turn a profit one month, the bank didn’t send thugs to demand payment,” she said of the Bank Muamalat loan for her shop. “It sent my account manager instead to help me rearrange the furniture and showcase the products better, because my profit is theirs, too.”

Hanifah, who wears a headscarf, declined to say how much she borrowed or what she clears each month.

Sharing Risk

The type of loan she took out from Bank Muamalat, whose Shariah-compliant lending rose 93 percent in the first nine months of last year, gets around the ban on interest by sharing both the borrower’s earnings and the lender’s risks. If there’s nothing left after expenses, borrowers owe nothing that month.

Lenders pay an agreed proportion of their profits as returns on customer deposits, causing rates to fluctuate depending on a bank’s profit. When the bank is more profitable, clients earn bigger returns on their savings.

Shariah-compliant banks can guard against currency swings by signing two sell-and-repurchase agreements, similar to the method used for fixed-rate deposits, in different currencies using agreed-upon exchange rates.

Indonesia will require non-Islamic banks operating Islamic- banking windows in their branches to set up independent units by 2015 to prompt them to inject more capital into the business, according to Setiadi of the central bank.

Shariah Council

Since July, Shariah-compliant banks in Indonesia have been allowed to lend to each other at fixed rates to manage excess cash, paving the way for savings accounts with a stable return similar to what non-Islamic banks pay for deposits.

Offering the same product to consumers may lead them to believe there’s no fundamental difference between Islamic and non-Islamic instruments, said Adiwarman Azwar Karim, a member of the National Shariah Board, part of the state-funded Indonesian Ulema Council. The council, founded in 1975, has the legal authority to issue decrees about whether products and actions comply with Shariah, which Bank Indonesia and the regulatory body at the Finance Ministry follow when drafting regulations.

HSBC Unit

HSBC’s Islamic banking unit, HSBC Amanah, has been offering Shariah-compliant retail and corporate products in Indonesia since 2003, nine years after starting in Malaysia. The bank earned $175 million in profits in Indonesia in the first half of last year and $288 million in Malaysia. The company doesn’t break out numbers for Islamic banking, Gareth Hewett, a spokesman for the bank in Hong Kong, said in an e-mailed response to questions.

Standard Chartered, which runs its wholesale Islamic business from Dubai and consumer Islamic banking from Kuala Lumpur, has been offering products for Muslims in Malaysia since 1993, according to Saifi. It started an Islamic banking subsidiary in Malaysia in 2008 calledStandard Chartered Saadiq Bhd. The lender in 2004 also purchased a stake in PT Bank Permata (BNLI), which it increased to 45 percent in 2006.

“It is very important that we continue to build a strong Islamic proposition that our customers have a choice of moving to Shariah-compliant products within the bank, if they choose to do so,” Saifi wrote in an e-mailed response to questions about Standard Chartered’s business in Indonesia. “We expect to see a much faster development of the product set in the country.”

Double Taxation

Nations including Pakistan, South Africa and Kazakhstan are seeking to develop Islamic finance by revising rules and offering incentives. Malaysia and Ireland have issued treaties to remove double taxation on the transfer of assets used in Islamic bonds and transactions.

The notes pay returns on assets to comply with the religion’s ban on interest. When an investor purchases sukuk, the asset is legally transferred to the bondholder and then returned to the issuer at maturity, which results in some structures incurring double sales tax.

Indonesia’s tax framework for such products is incomplete, leaving potential sukuk issuers uncertain whether they will be required to pay taxes on the sale and repurchase of underlying assets, said Badlisyah Abdul Ghani, head of Islamic banking at Kuala Lumpur-based CIMB Group Holdings Bhd. (CIMB), the world’s second- largest sukuk underwriter.

Catching Malaysia

Indonesia’s capital market regulatory agency has ensured that no corporate sukuk issuance incurred double transaction taxes, said Etty Retno Wulandari, a director. To dismiss the misperception, Bank Indonesia has asked the taxation department since 2009 to send out a letter stating that Islamic products will receive tax exemptions as needed to place them on equal footing with non-Islamic bonds, Setiadi said.

Malaysia’s Securities Commission established a Shariah advisory council in 1996 to vet sukuk offerings before releasing a comprehensive guideline on how companies can issue Islamic bonds in 2004. Indonesia has yet to publish broad guidelines on offering sukuk. The separate pronouncements to allow the government and companies to sell such bonds are sufficient, Wulandari at the regulatory agency said.

“Indonesia will easily leave Malaysia in its dust once it completes its regulatory framework and tax neutrality laws,” said Badlisyah of CIMB. “Its market share will catch up to Malaysia overnight.”

image copyright: Ed Wray/Bloomberg