Islamic bond to fund fiscal deficit

Pakistan will make another leap in Islamic banking sometimes this month when it launches its first Islamic bond or sukuk in the domestic financial market to reduce borrowings from the State Bank of Pakistan which skyrocketed recently.In the just-ended financial year, the government borrowed Rs625 billion from the central bank to finance its fiscal deficit which rose to 7.4 per cent of GDP, compared with 4.5 per cent in the preceding year.

The auction target for the sukuk, according to Dow Jones, is stated to be Rs15-20 billion. The coupon rate on these bonds will be close to six-month treasury bill cut off yields of 11.49 per cent. Standard Chartered Bank and Dubai Islamic Bank will assist in its sale.

Market circles are optimistic about its success since there is ample appetite within the Islamic banking industry. If this sukuk goes well, Pakistan will launch several bond offers of this kind in the months ahead this fiscal year. By launching its first sukuk, the government wants to diversify its source of funding at a time when the Islamic finance industry is searching for more investment opportunities.

Contrary to phenomenal progress made in the Middle East and some western countries, Islamic finance in Pakistan has little avenues to invest, and most of the time their funds remain idle. But compared to Indonesia where Islamic banks account for only 2.1 per cent of the total industry, Pakistani Islamic banks’s share in total banking activity in the country is 4.1 per cent.Indonesia said last week it has failed to raise what it had hoped from its maiden, rupiah-denominated, Islamic bond (sukuk) offerings. But analysts said the issuance was solid and has at least paved the way for a foreign currency sukuk later in the year.

The offering is an important development for Indonesia’s Islamic finance sector, which lags behind that of neighbouring Malaysia which is much ahead.Malaysia is, in fact, on its way to become a global leader in the Islamic finance industry which is believed to be worth one to two trillion dollars at the moment. It has the world’s largest sukuk market with $66 billion or 62.6 per cent of global outstanding sukuk issuance as at end-June this year. Its Islamic banking has 12 per cent market share in the country. It has decided to exempt taxes for three years on fees and profits earned from its foreign currency Islamic bonds outside the country with a view to boost the industry.Islamic banks in Pakistan hold about Rs206 billion of assets, and have 2.6 per cent and 4.3 per cent market share in deposits and financing.

The State Bank plans to raise market share of Islamic banking to 12 per cent by 2012 by evolving a regulatory framework, enhancing the spectrum of Islamic banking and strengthening Shariah compliance mechanism.In 2003, the market share of Islamic banking in Pakistan was mere 0.5 per cent and there was only one Islamic bank. Now, the deposits of Islamic banks have reached Rs60 billion. Today, there are six Islamic banks with 230 branches and 12 conventional banks have 103 outlets for Islamic banking.

The Islamic finance has shown spectacular growth over the past ten years and is one of the fastest-growing in the world. It presents unique opportunities to both new entrants and existing players. There are now over 300 institutions offering Shariah-compliant banking, with an asset base of around $250-500 billion.

Currently, Islamic finance activities are dominated by the GCC countries and Malaysia.Although the roots of Islamic finance lie in Islamic principles since the days of the Holy Prophet, its development as an industry is relatively new. While conventional commercial banks provide financial intermediation services on the basis of interest (charged and paid), the basic premise of Islamic finance is the prohibition of interest.

Islamic bankers have developed a number of instruments that perform financial intermediation functions without the involvement of interest. From a small banking experiment in rural Egypt during the 1960s, Islamic finance is currently expanding at a rate of 10-15 per cent per annum.

It is now the preferred channel of banking for one fifth of humanity.Meanwhile, Saudi utilities and corporates are emerging as major drivers of Islamic finance transactions with a spate of high-powered and, in some instances, pioneering structures coming to the market in the last few months. This augurs well for the Islamic finance sector, especially in Gulf Cooperation Council (GCC) countries, where governments play key role and actively participate in establishing Islamic financial institutions (IFIs) in an effort to take greater control of the sector which has been growing at an estimated 20 per cent growth rate per annum.

Islamic bankers would prefer more active involvement of Saudi and GCC private sector in view of the growing migration of capital into the Islamic finance sector. Although the rapid growth of this sector in the GCC is led by both private and government-owned entities but the latter is still playing an ever-increasing role as is evident from recent establishment of Alinma Bank in Saudi Arabia, Masraf Al-Rayan in Qatar; Al-Hilal Bank in Abu Dhabi; Ajman bank in Ajman and Noor Islamic Bank in Dubai.

In a recent report, Moody’s Investors Service, the international credit rating agency, said that GCC governments may get more involved in the sector because they “do not want to see the Islamic banking industry over-dominated by the private sector, and (for that purpose) want to keep the whole thing under control.”

The reason is that “if governments have an increasing share of ownership in IFIs, the risk of consumers perceiving an IFI as insufficiently compliant with Shariah is somewhat mitigated.”The GCC governments are concerned that the fast-paced growth of the sector could lead to some lapses in corporate governance and Shariah compliance because their region is under-regulated.

There is lack of adequate enforcement of policies and there is a litany of conflicts of interest including instances where ministers are allowed to serve on the board of IFIs.Saudi Arabia is by far the biggest player in the Islamic finance market simply because the kingdom boasts the largest pool of funds in the sector. Bahrain may have several IFIs incorporated there but most of the shareholders’ equity comes from Saudi high net worth individuals and institutions.The expansion of Islamic industry is largely centred on retail and consumer finance especially housing finance and current accounts and savings products; infrastructure and project finance; acquisition finance; and real estate development finance.