MALAYSIAN ISLAMIC FINANCE Issuers and Investors Forum 2006

Current Overview of the Malaysian Islamic
Capital Market

By Mohd Effendi bin Abdullah and Salina Mohd Burhan

The Malaysian Islamic Capital Market (ICM) has grown by leaps and bounds in recent years and is now an integral part of the broader capital market landscape. The ICM complements the conventional capital market by providing value-added services with a sufficiently wide array of products that meet investors’ diverse needs for a broad range of instruments, and has effectively mobilized and channeled funds to fuel the country’s economic growth.

Basically, ICM is a capital market where all its activities are undertaken under Islamic law. The list of various capital market products available today include Shariah compliant debt and equity securities, Islamic unit trusts, Shariah indices, warrants and crude palm oil futures contracts, together with Islamic stockbroking. These instruments and services do not only cater to the appetite of perceptive Muslims who seek out Shariah compliant products, but also serve as viable and competitive alternatives to conventional products for non-Muslim investors.

In order to preserve the sanctity of the ICM products and services, the Securities Commission (SC) established the Shariah Advisory Council (SAC) in 1996 to advise on all Shariah matters pertaining to the ICM. Malaysia is amongst the few countries in the world to have established a Shariah Authority at the national level, where the other SAC sits at Bank Negara Malaysia (BNM) and is the sole Shariah authority in Islamic banking. This model has proven to be one of the key success factors in promoting the ICM. In addition, to further expedite Malaysia’s vision to be internationally competitive in this sector, the Capital Market Masterplan (CMP), established in 2001, provides a strategic roadmap for the development of the overall capital market. We have now reached phase three of the implementation of the CMP, where we are required to enhance market processes, infrastructure and international positioning in areas of comparative and competitive advantage. The CMP has also identified the ICM as a key component of Malaysia’s capital market, with the objective of establishing Malaysia as an international ICM market center.

Performance highlights of the ICM
The CMP, sound regulatory framework and the establishment of the SAC has enabled and facilitated the development of the ICM. The ICM today is a significant part of Malaysia’s capital market. In the equity market, 871 companies out of the 1,024 companies on Bursa Malaysia are Shariah compliant, representing 85% of total market capitalization as at the end of April 2006. The capital market also plays an important role in mobilizing savings through the investment management industry, as exemplified by Islamic unit trusts and Shariah compliant funds management. As at the end of June 2006, the net asset value (NAV) of Islamic unit trust funds was US$2.35 billion (RM8.57 billion), representing 8.13% of total industry NAV.

The composition of Islamic securities issues approved by the SC (excluding issuance by Cagamas) has been on a continual upward trend, especially since the first quarter of 2005. Back-tracking a little, from 2002 to 2004, the size of approved Islamic securities had been below the region of US$2.19 billion (RM8.0 billion) for every quarterly period during those years. Islamic securities issues had overall been less than conventional issues (although an exception occurred in the second quarter of 2004, when Islamic exceeded conventional issues). Islamic securities, however, took a sharp positive about-turn and overshot conventional issues throughout 2005, with total approved issues of over US$11.77 billion (RM43.0 billion), which accounted for 70% of gross issuance of Private Debt Securities (PDS). For the first half of 2006, Islamic securities issues already reached US$4.35 billion (RM15.9 billion), with a total of 31 approved issues by the SC, representing 53% of total PDS.

Trends and Islamic principles applied
A snapshot of the Islamic securities approved by the SC in the first half of 2006 reveals that a substantial portion of the issues were based on the Shariah principles of Musharakah, as a result of a sizeable Islamic securities program by Khazanah Nasional.

In fact, since 2004 the market began to witness a decline in Islamic securities issuance structured under the principles of Bai Bithaman Ajil (BBA) and Murabahah. There is now a shift towards the Islamic principles of Istisnah, Ijarah and Musharakah.

Could this mean that BBA and Murabahah are slowly losing their appeal as being the preferred choice of underlying Shariah contracts for Islamic securities issues amongst issuers? If this is so, then could this be attributed to the fact that issuers are moving away from Islamic securities, which involves securitization of debt, and mirrors the debt structure of conventional securities? In the international market, BBA and Murabahah are generally not widely accepted because the securities issued are debt in nature (Bai Dayn), and also because of the two-party nature of the purchase and sale transactions (Bai Inah).

Prior to the release of the Guidelines on the Offering of Islamic Securities (Islamic Securities Guidelines) by the SC in July 2004, Islamic bonds relyied on the definition of “debentures” under the Guidelines on the Offering of Private Debt Securities. As such, the local market was limited to the issuance of Islamic bonds under the principles of BBA and Murabahah, which are based on the contracts of exchange. Apart from enhancing the regulatory framework for Islamic securities, the Islamic Securities Guidelines have also decoupled Islamic bonds from debentures and broadened the types of Islamic securities issued in Malaysia. This has subsequently lead to the development of more sophisticated and innovative products and facilitated the issuances of internationally acceptable instruments structured under contracts of participation, like the contract of Musharakah (profit and loss sharing) and Mudharabah (profit sharing).

The sophistication and innovativeness of ICM products are not sufficient if they are only accepted domestically. Malaysia’s success in bringing on-stream varied forms of Islamic securities must be replicated internationally. Structuring of Islamic securities must now focus on convergence and similarities to international standards in order to target the global financial system, particularly the Gulf Cooperation Council (GCC) market. Sukuk, for instance, has been in the limelight in recent years. A Sukuk structure is typically a type of securitization backed by assets acceptable under Shariah law, and has been used to finance a range of projects. In the Middle East, most of the Sukuk are structured according to the Shariah principles of Ijarah, Istisnah and Musharakah. It should be noted that for the Sukuk to be tradable (as per the standpoint of Middle Eastern scholars), they generally cannot be linked to Islamic contracts such as BBA and Murabahah, as these contravene the very essence of debt trading (Bai Dayn).

Nevertheless, this does not mean that we should start phasing out the present Bai Bithaman Ajil Debt Securities (BaIDS) and Murabahah Notes Issuance Facility (MUNIF) entirely. These instruments have been approved by the SAC and hence are tradable in the local market. But as we shift our focus from the domestic market to the global market, as outlined by the CMP, it is vital for us to churn out globally acceptable Islamic instruments that meet international standards as closely as possible.

Latest developments in the ICM
There has been a flurry of activity in the ICM, punctuated by significant developments in the market. The market has shifted from product adaptation to product origination, with a focus on convergence with international standards. Market-driven initiatives have led to further product innovation and development. Some recent achievements in the local market include these notable Islamic securities issues:

First Mudharabah Islamic Bond (by PG Municipal Assets)

• First domestic Islamic corporate bond structured for a municipal.
• Malaysia’s first structured transaction backed by property taxes.
• Malaysia’s first issuance of Islamic securities under the Mudharabah contract.

World’s first Islamic Residential Mortgage-Backed Securities (by Cagamas MBS)

• World’s first rated Islamic RMBS under the principle of Musharakah.
• Involved the securitization of a pool of government staff Islamic home financing (new asset class).

First Sukuk Musharakah (by Musharakah One Capital)

• The Sukuk proceeds were used to acquire the receivables comprising rights, title, interests and benefits to the payment obligations of the Government of Malaysia for the supply of teaching equipment and services.

Recent measures by the SC to facilitate cross-border issuance and investment have led to several supranationals issuing ringgit bonds. A recent landmark deal which created a ripple effect in the local ICM was the successful 760 million ringgit-denominated Islamic bond issue by the International Bank of Reconstruction and Development (IBRD), namely the Wawasan Bonds. The Wawasan Bonds, being the third issuance by a supranational locally, marked the bond debut of the World Bank in Malaysia. This Shariah compliant bond served as another milestone in the development of the ICM, after the first Islamic supranational issue by International Financial Corporation back in 2004. More Islamic supranational issues such as these are certainly to be welcomed, as they would contribute to the further broadening and deepening of the domestic ICM.

In line with Malaysia’s efforts to further promote the ICM, the SC issued the Guidelines for Islamic REITs in November 2005. Malaysia is the first jurisdiction in the global Islamic financial sector to issue such guidelines, thus setting a global benchmark for the development of Islamic REITs. This achievement further enhances Malaysia’s lead role in the ICM and will further promote and accelerate the growth of a competitive ICM in the global stance. The aim of introducing of the Guidelines for Islamic REITs is to provide a new investment opportunity for those who wish to invest in real estate through Shariah compliant capital market instruments and widen the investor base who normally would not subscribe to non-Shariah compliant investments. These guidelines facilitate the creation of a new asset class for investors, as well as allowing further diversification by fund managers of their investment sources and portfolios, and also hedging against fluctuations in the equities and commodities markets. They also offer foreign investors seeking Shariah compliant instruments, in particular Middle East investors, with an opportunity to invest in the Malaysian real estate market without the hassle and responsibilities associated with the direct ownership of such assets. The inaugural issuance by KPJ Healthcare marked another first for Malaysia, as the first listed Islamic healthcare REITs in the world, for the Al Aqar KPJ REIT was launched on the 24th July 2006.

Another milestone achieved is the establishment of the Malaysia International Islamic Financial Center (MIFC), launched in August by the Governor of Bank Negara Malaysia (BNM) at MIF 2006 to facilitate and further expedite global integration via the offering of Islamic financial products and services in international currencies from anywhere in Malaysia. The MIFC will introduce several immediate key measures and initiatives to ensure growth in this sector is expedited.

In order to stimulate more innovative and attractive Islamic financial instruments, incentives will be given to draw the best foreign talents and market players to the MIFC. All these measures and initiatives have been formulated to equip Malaysia to become the center of origination, issuance
and trading of Islamic capital market and treasury
instruments, Islamic wealth fund management, international currency Islamic financial services, as well as Takaful and re-Takaful business.

The Government’s strong and continued support of the ICM is also a key success factor for Malaysia. The recent 2007 Budget announcement gave resounding support to the MIFC initiative and also provided other tax allowances relating to issuances of Islamic securities. Malaysia’s government is keen to promote the country as an Islamic financial hub, as evidenced by the inaugural issue of Sukuk Ijarah by BNM in February 2006, with the aim of setting a benchmark for other Islamic securities.

Singapore is aspiring to play the role of a gateway to Asia, especially China, for Islamic investments from the Gulf. As a matter of fact, Singapore has implemented measures conducive to the growth of Islamic finance in the country and in the region. These measures include local regulatory changes and the alignment of taxes on Islamic financial products with those levied on contracts offered by conventional institutions.

It was reported that as at July 2006, there was more than US$315.0 million (S$500.0 million) in Takaful funds and approximately US$1.26 billion (S$2.0 billion) worth of Shariah compliant real estate funds managed out of Singapore. Indeed, Singapore is encouraging the growth of Islamic finance in order to broaden the array of financial services and reinforce its status as an international finance center and an Islamic financial hub.

Nonetheless, Malaysia should maintain its momentum whilst keeping an eye on possible competition, not just from Singapore but also from the other emerging Asian countries such as Indonesia, Thailand and Brunei.

However, with the continued commitment of the government and regulators, as well as contributions from market participants, Malaysia will be the chosen international Islamic financial center for many years to come.

The authors are Director/Head of Islamic Markets & Public Sector and Associate Director, Islamic Markets, respectively, at AmMerchant Bank, tel: +603 2072 7748/ +603 2074 6569,
fax: +60 3 2031 2189, email: effendi@ambg.com.my and salina-burhan@ambg.com.my.