While the Gulf has emerged as a hub for Islamic finance in the past decade, the centre of gravity in the sharia-compliant universe remains firmly fixed thousands of miles to the east.

Malaysia dominates global issuance of sukuk (Islamic bonds) and is a leader in sharia-compliant lending activity and fund management. Islamic banking assets and assets under management in the Asian country are worth an estimated $1.2 trillion. The rate of growth in recent years is equally impressive. As of September 2011, Islamic assets accounted for 21.6 per cent of total banking assets in Malaysia, an increase from 12 per cent in December 2006.

On Bursa Malaysia (the Malay stock exchange) about two-thirds of the listed securities (by stock market capitalisation) are sharia-compliant. The country’s Islamic debt securities market is the largest in the world, with $34bn of domestic corporate bonds outstanding. 

Pivotal role

The government’s capital market masterplan predicts the size of Malaysia’s Islamic capital market to grow by an average of 10.6 per cent a year to top $1 trillion by 2020. Sukuk are poised to play a pivotal role in this growth, with the segment expected to account for 46 per cent of this volume.

Kuala Lumpur has extended its dominance of the global sukuk market and held 68 per cent of the $210bn-worth of sukuk outstanding globally at end of 2011. That pace has been maintained in the first six months of 2012. According to Malaysia-based Kuwait Finance House subsidiary KFH-Research, Malaysia accounted for $46.8bn of the $66.4bn of global sukuk issued in the first half of the year. Large Malaysian banks have lengthy issuance pipelines. CIMB Islamic Bank alone holds more than $17bn.

Malaysia’s voluminous issuance pipeline has compelled Gulf-based rivals to target investors there. Bahrain-based Gulf International Bank has a $1.1bn sukuk al-wakalah medium-term note programme in Malaysia while Kuwait’s Gulf Investment Corporation issued $101.6m Malaysian Ringgit-denominate sukuk with a 10 and 15-year tranche in June. 

Malaysia’s Islamic finance industry has felt the positive impact of state efforts to support growth in the sector. A more liberal interpretation of Islamic financial norms and a heavier focus on dismantling barriers to foreign investment has helped shore up the country’s status as a global Islamic finance hub, as have attractive tax incentives.

Whereas Gulf governments, such as Qatar, are closing down international banks’ Islamic windows, Malaysia pursues a liberal agenda in which the foreign equity ceiling in Islamic financial institutions is 70 per cent, compared to 30 per cent for conventional banks.  

These measures have collectively helped foster growth in the Islamic finance sector. Sukuk issuance is becoming cheaper and more cost-effective. According to an assessment of Malaysia’s sukuk programme issued in June by the Washington-headquartered IMF, some sukuk issues actually have a few basis points advantage over conventional bond issues.

“The Islamic finance sector is thriving, with more and more Islamic banks being established in Malaysia,” says Allan Redimerio, a Singapore-based analyst at US ratings agency Standard & Poor’s (S&P). “Takaful (Islamic insurance) demand is growing and there are more than 150 sharia-compliant funds now registered in Malaysia. There’s a lot of Islamic capital looking for assets and that is really supporting the large issuances of sukuk.”

Malaysia’s success has not yet been replicated elsewhere in Southeast Asia. “The other countries are not really there yet. Indonesia is the up-and-coming market, but the gulf between Malaysia and Indonesia is still very large,” says Redimerio.

Asian competition

Despite this, other countries in the region are trying to grab market share. “Japan has revised its laws to allow for more sukuk issuance, but we’re not really seeing any activity there. Singapore has also introduced a level playing field [in terms of taxation], but there’s not really much activity. It’s only really Indonesia that is entering the market in a serious way,” says Redimerio.

Indonesia’s primary sukuk market registered growth in issuance of more than 200 per cent over the year to the end of June 2012 to $142m.  Sukuk issuance is dominated by its project-sukuk programme, focused on supporting infrastructure developments.

Indonesia is looking to emulate Malaysia’s success, deploying Islamic finance for infrastructure development, given its large infrastructure needs and a pressing requirement to attract private capital to fund these investments. The world’s most populous Muslim nation plans to spend $200bn to expand and upgrade infrastructure in the 2010-14 period. 

The fit is good, says S&P. Islamic finance is well matched for infrastructure projects such as power plants and toll roads. Once they are completed, such projects typically benefit from long-term concession agreements of 15 to 20 years, or beyond, and usually offer stable and predictable cash flows. This appeals to sukuk investors.

South African Islamic finance market

With Malaysia and the Gulf firmly entrenched as the world’s dominant Islamic finance centres, Europe and Africa are also bidding for a slice of global sharia activity. South Africa in particular has set out its stall as a non-Muslim contender for Islamic finance deals.

Late last year, the South African government invited banks to bid for the advisory mandate on a sovereign sukuk, designed to diversify the country’s funding and investor base. Six banks are advising on the ambitious debt issuance programme: Bahrain’s Al-Baraka Banking Group; BNP Paribas of France; Kuwait’s Liquidity Management House; the US’ Nova Capital Partners; and South Africa-based banks Regiments Capital and Standard Bank. 

South Africa is also looking to attract Islamic fund investments. Africa’s first sharia-compliant exchange traded fund (ETF) was launched in 2009 by Johannesburg-based NewFunds, a joint venture of Absa Capital and Vunani Capital. The ETF includes-sharia-compliant companies picked from stocks listed on the main board of the Johannesburg Stock Exchange.

European centres have also seen an increase in activity, with London, Dublin and Luxembourg vying for a larger slice of the Islamic fund business.

Their strategies have been designed to attract Muslim investors from further afield, such as Asia and the Middle East. The Malaysian-US joint venture CIMB-Principal Islamic Asset Management is setting up a range of investment schemes to operate through the EU, and three UCITS-compliant Islamic equity funds (Undertakings for Collective Investment in Transferable Securities – a form of wrapping that effectively provides for funds to be distributed across the EU) were launched early in 2011.

Conventional European asset managers are also eyeing the sharia market. In the UK, Aberdeen Asset Management will launch its first Islamic stock funds targeted at Asian investors later this year. The funds will be operated from Malaysia pending regulatory approval.

With ever-increasing numbers of Middle Eastern investors hungry for European assets, the attraction of structuring investment products and debt securities in a sharia-compliant manner is huge. “There’s a funding need and a lack of liquidity in the conventional markets in Europe,” says Farmida Bi, European head of Islamic finance at law firm Norton Rose. “Meanwhile, we are seeing interest, in particular, from Middle Eastern and Asian investors searching for investment bargains in Europe. As a result, various jurisdictions are responding by trying to accommodate these investors.”

Bi says there is healthy activity in Germany’s real estate sector, as well as rising interest in Spain and Greece, as Middle Eastern investors try to pick up assets at keen prices.

London platform for Islamic finance

While Luxembourg and Dublin have implemented significant legal reforms in a bid to attract Islamic investors, it is the City of London – Europe’s top financial centre – that has worked hardest to attract Islamic investment. London has made tax treatment and the regulatory architecture as simple as possible for investors to conduct sharia transactions as they would in Kuala Lumpur or Manama.

The UK’s Financial Services Authority (FSA) authorised the first Islamic bank in Europe more than a decade ago. Since then, four other banks have received authorisation. The UK currently has significantly more sharia-compliant assets than any other European country.

“London has a sukuk platform and supporting legislation, so in the future more corporates may use sukuk to access liquidity from the Islamic market, in particular the GCC,” says Nigel Denison, head of Markets and Asset Management at Bank of London and the Middle East, Western Europe’s largest Islamic lender.

Europe will never be in a position to compete with the GCC or Malaysia in terms of overall penetration of Islamic finance. But the growing globalisation of Muslim-owned capital flows suggests sharia-compliance will become more prominent in Europe’s future financial landscape. That can only be healthy for the future development of Islamic finance.