MALAYSIAN ISLAMIC FINANCE Issuers and Investors Forum 2006

Malaysia – The Center of Islamic Product Innovation and Global Recognition

By Islamic Capital Markets, Aseambankers

Islamic finance in Malaysia has come a long way and its success story is well-known on the international scene. Malaysia has been consistent in its efforts to be at the forefront of Islamic finance, progressing from the first issuance of Islamic bonds by Shell Malaysia in 1990, to the establishment of the country’s first Islamic unit trust fund by Arab Malaysian Unit Trust in 1993. Subsequently, in 1994, BIMB Securities was established, making it the first fully fledged Islamic stockbroking company.

The annual growth rate of global Islamic finance is estimated at between 12% and 15%. The growth of Islamic capital markets in Malaysia has far exceeded this projection. The number of Islamic securities has grown to 85% of those listed on Bursa Malaysia. More than a third of bond issues in Malaysia are Shariah compliant, and regulators estimate that half of the world’s Islamic capital market funds are located in the country.

A significant area of growth has been seen within the Islamic capital market itself. Today, this market has the full complement of products, infrastructure, institutions, intermediaries and investors, contributing to the development and greater depth of the capital market. Islamic capital market products and services have also become an integral part of the capital market landscape, able to offer viable and competitive alternatives to conventional products and services. They have become increasingly popular and acceptable, both as financing and investment tools.

Broad product range
The growth of the Islamic capital market is primarily due to the range of Islamic products available in Malaysia. Since the introduction of the Islamic capital market in 1983, Malaysia-based Islamic banks have been applying three basic concepts, namely Bai Bithaman Ajil (BBA) (deferred payment sale contract), Bai Inah (sell and buy-back contract) and Bai Dayn (debt trading contract). All three contracts are based on a sale and purchase transaction where a tangible asset is used as the medium of the transaction. These three Bai contracts constitute over 80% of the Islamic banking portfolio; however, they are perceived to be less favored by Islamic practitioners outside of Malaysia.

Over the years, the BBA structure has been the preferred choice to finance long gestation period projects such as infrastructure projects. Under this principle, the financier purchases an asset from the issuer and sells it back to the same party at a premium. Besides BBA, another popular Islamic capital market tool is the Murabahah concept, which caters for short to medium-term requirements. These two financing structures have dominated the local scene largely because they are easily understood by issuers and investors.
Nevertheless, lately the Malaysian Islamic bond market has ventured into new, innovative structures, taking into account the growing interest in Islamic papers from the Middle East, as well as other countries. In 2005, several new Islamic financial products were introduced, which included residential mortgage-backed securities, commodity-based financing, as well as investment and equity-linked products based on Musharakah, Mudarabah and Ijarah.

Innovation
The further growth and development of the Islamic financial system will depend largely on the nature of innovations introduced to the market. Over the past 10 years we have witnessed the introduction of various Islamic products such as Shariah compliant stocks, Sukuk, Islamic unit trust funds and Islamic equity indices. Malaysia has pioneered many “firsts” in Islamic financing. Among the key milestones that have paved the way for Malaysia to become the leading Islamic finance hub are:

• Midciti Resources (1998) – first debt structure; subsequently adopted as an approved Islamic structure by the Securities Commission.
• Government of Malaysia (2002) – first tradable and rated global sovereign Sukuk Ijarah in the world.
• SKS Power’s US$1.53 billion (RM5.6 billion) Sukuk Istisnah (2003) – first tradable Sukuk Istisnah in the world.
• Maybank (2005) – first Islamic subordinated debt in the world issued using Ijarah Thumma Bai financing contracts for the purchase of motor vehicles.

The Malaysian Global Sukuk in 2002 was the first global sovereign Islamic bond issued in the international bond market. It reinforced Malaysia’s position as a premier center for Islamic capital markets. Malaysia has proven to the global financial system that Islamic products can be as competitive as conventional products, if not more so. The pricing of the Malaysian Global Sukuk was similar to conventional bond pricing and was oversubscribed not only by Islamic investors but also by conventional investors. The issue set a global precedent for the development of more global Islamic products. Countries such as Qatar and Bahrain have now also launched global Sukuk.

The introduction of a benchmark index can often act as a catalyst for a more rapid pace of development of the financial market and the recognition of a new asset class. In this regard, the Dow Jones Citigroup Sukuk Index was launched in Malaysia in May 2006 to be the first index to measure the performance of global Islamic Sukuk. It is a benchmark for investors seeking exposure to Shariah compliant instruments.

Aseambankers Malaysia, the investment banking arm of Maybank, has lead arranged many notable Islamic debt issues locally and regionally. Among them are the Islamic subordinated debt issuance by Maybank, which became the world’s first Islamic subordinated debt. This is essentially a deferred payment structure, where the proceeds from the issuance are utilized by the Islamic banking department for working capital purposes. The assets in this transaction were a pool of specifically identified mortgage assets, which were mortgage transaction concluded between the purchasers (customers) and the issuer under the Ijarah Thumma Bai concept.

Another landmark issue lead arranged by Aseambankers was Malaysia’s first rated residential mortgage-backed securities, issued by Cagamas MBS in ringgit and distributed regionally. The instrument involved the securitization of a pool of government staff housing loans valued at US$435.9 million (RM1.6 billion). The instrument was rated AAA by both Malaysian Rating Corporation (MARC) and Rating Agency Malaysia (RAM). The issue size was oversubscribed by 5.6 times by both local and foreign investors. Pursuant to this issue, Cagamas MBS issued the second residential mortgage-backed securities under the Musharakah principle. The securitization of the government staff home financing under the Musharakah structure reflected the Malaysian Government’s continuous and innovative effort to broaden the local Islamic capital market by introducing new asset classes and simultaneously creating a reference yield curve for the issuance of similar long-term Islamic asset-backed securities (ABS).

Another important and innovative product introduced in Malaysia recently has been the Islamic cross-currency swap. This is indeed a significant development in broadening the range of Islamic capital market instruments. The Islamic cross-currency swap is an arrangement between two parties to exchange a series of profit and/or principal payment denominated in one currency for another series of profit and/or principal payment denominated in another currency, based on a notional principal amount over an agreed period. To ensure that the structure is Middle East Shariah compliant, the arrangement uses commodity Murabahah transactions as the underlying transactions.

Government support
The Government of Malaysia has continuously encouraged the growth of the Islamic capital markets in Malaysia. As part of its initiative to assist in the development of Islamic debt, the Government has announced incentives in relation to tax deduction for Islamic private debt securities and stamp duty waiver on financing facilities under Islamic banking. Furthermore, the establishment of separate guidelines for Islamic debt instruments by the Securities Commission was another important step for the Islamic financial arena in Malaysia. All Islamic debt instruments now have separate guidelines. More recently, Islamic ABS guidelines were also introduced by regulators and, as a continuation of the efforts to facilitate the development of new Islamic instruments, the Securities Commission also released guidelines on Islamic Real Estate Investment Trusts (I-REITs) in 2005.

The guidelines on I-REITs are the first in the global Islamic financial sector. Their introduction will create a new Shariah compliant asset class for investors seeking to diversify their investments. I-REITs will allow foreign investors, in particular Middle Eastern investors, to invest in Malaysia’s property market without the hassle and responsibilities associated with direct ownership of company. The recent 2007 budget announcement is expected to further encourage the growth of Islamic capital markets in the country. Incentives in the form of tax reductions for investments in REITS and other tax relief will further promote Malaysia as the International Islamic Financial Center.

Conclusion
In conclusion, the range of Islamic products and services that are available for both local and international investors is testimony to Malaysia’s leading edge in this area. With the expected increase in the numbers of Islamic financial institutions, demand for competitive Islamic products and services is likely to increase. The key challenge in moving forward will be the ability of Islamic financial products and services to penetrate the mainstream financial industry and contribute to the overall development of the financial market worldwide.