Despite the global financial downturn, Islamic finance has seen astounding growth. North Asia is looking at cashing in on the action – Hong Kong plans to introduce legislative changes to spur Islamic finance, and Japan is poised for its first sukuk issuance. Can North Asia become a viable destination for shariah-compliant financing? Kanishk Verghese investigates
Demand seems to be spicing up for all things Islamic. In Hong Kong, the number of halal restaurants is on the rise, and the territory’s financial secretary, John Tsang, has announced plans in the 2012 and 2013 budget to introduce legislative changes to encourage Islamic finance. Meanwhile, Japan has already amended its laws towards shariah compliance. The stage is set for the two jurisdictions to emerge as players for Islamic finance in North Asia.
Islamic finance does not sound congruent with North Asia, which lacks large Muslim populations. Compare this to Southeast Asia, which has two Muslim-dominant nations, namely Malaysia and Indonesia, where such funding is common. However, Hong Kong is promoting Islamic-friendly funding, driven by the demand for business into China from these resource-abundant Islamic countries. Japan too, is getting in on the action, with the amendments that kicked in late last year – the nation now eagerly awaits its first issuance of a sukuk, or Islamic bond. Both Japan and Hong Kong face tough competition from Malaysia and Indonesia though, which together boast the lion’s share of the global sukuk market.
Hong Kong: Take two
Hong Kong’s interest in Islamic finance first sparked in 2008, but soon waned. The issue is now back on the agenda, but why? For a start, despite the global credit crisis, practitioners note the astounding growth in Islamic financing. In fact, HSBC has forecast global sukuk volume to hit $44 billion in 2012, a sizeable leap forward from $26.5 billion last year. “What we are seeing in Asia is an extension of that global trend which has been taking place,” says Gregory Man, a lawyer at Clifford Chance’s Hong Kong office. “Over the last couple of years, given the development of Islamic finance, it has really emerged as a credible alternative form of financing to other conventional forms, which have been open to borrowers traditionally.”
To open Hong Kong’s doors to this new form of financing, the government announced legislative changes and published a consultation paper on tax changes in March. The proposals include revisions to Hong Kong’s profits tax, property tax, and stamp duty to help place Islamic bonds on a level playing field with conventional financing. “It is obviously a very positive thing,” says Darren Bowdern, a partner at KPMG China. “The proposal is making sure that the arrangement and instrument is treated in the same manner as a more conventional financing arrangement, like a loan or a bond. This puts them on par, whereas in the absence of these rules, they can be treated very differently.”
For sukuk to be economically feasible in Hong Kong, issuers need legislation that ensures tax neutrality. Islamic finance transactions often require asset ownership to be transferred more than once between parties. This often results in additional fees, making them costlier than conventional structures. Islamic financial instruments typically sidestep the payment of interest – prohibited under shariah law – by structuring returns in the form of profits, distributions, or rentals with respect to property.
For its part, the government is hopeful that the proposed amendments will see the light of day, and breathe life into the Islamic bond market in Hong Kong. So far, the territory has only seen a 500 million yuan ($79 million), three-year sukuk issue from Malaysia’s Khazanah Nasional in October 2011. However, since Khazanah’s underlying assets are in Malaysia, the sukuk issue was exempted from Hong Kong taxes and stamp duty.
The government has explored new strategies to stimulate the trading of sukuk. Malaysian investors can buy yuan-denominated “dim sum” bonds in Hong Kong, and their Hong Kong counterparts can access sukuk under a pilot platform initiated in March this year by the Hong Kong Monetary Authority with Bank Negara Malaysia and Euroclear Bank. “It will take a little time before we see results coming out of the platform. But, I think certainly behind the scenes, we will start to see a greater flow of investments going from North Asia through Hong Kong into Malaysia, and then from Malaysia up to Hong Kong,” says Barzilai.
Land of the rising sukuk
While Hong Kong waits, Japan is already ahead – its shariah-compliant amendment to the Asset Securitisation Law, coupled with tax reforms, have been in place since November 2011. “When you look at the amendments, they hit all the right spots. I think as all mature markets, responsible market players and governments need to do, Japan needs to be able to at least have the regime in place so that the market can develop if it needs to,” says Leng-Fong Lai, a partner at Clifford Chance in Tokyo. “It is not going to solve all the problems, but it is a strong step in the right direction,” agrees Barzilai.
Although a sukuk deal has yet to come to fruition, optimism for a transaction within the year remains high. Practitioners believe that the well-defined rules have set up, in theory at least, a comprehensive regime. Unlike many parts of the world, Japan is still a rich source of funding. Now that the changes to the law have made Islamic financing in Japan more attractive, institutions outside Japan that require shariah-compliant funding can now tap this market. Lai admits having received a number of inquiries about the recent amendments, and genuine interest in utilising this for financing investments into Japan. “The scenario I have painted is not a hypothetical one. People have talked to us about this possibility,” he adds.
Causes for concern?
The wheels are certainly in motion to ignite Islamic finance in North Asia. But how quickly are they turning? At this stage, it may be difficult to gauge whether the new rules will successfully encourage shariah-compliant financing in the region. Bowdern believes that it may be hard for Islamic finance to compete against the more conventional lending practices. “If the cost of putting an Islamic platform in place is much higher than a more traditional financing arrangement, it is going to deter sponsors from issuing these types of products,” he says.
Another concern is that potential sukuk issuers may be inclined to adopt a wait-and-see approach. Being the first to act has its benefits, but it can also often be a deterrent. The reason: pioneering such a move could mean higher transaction fees, making particularly cost-conscious investors look elsewhere. Lai puts it as: “If you are the first in anything, typically you would need a lot of investment. If you are looking at it from an economic perspective and there is an alternative, it may be tempting to go that way rather than trying something new.”
Competing with Southeast Asia
Islamic finance may be new to North Asia, but it is certainly no stranger in Southeast Asia. Malaysia’s burgeoning sukuk market is a fearsome rival to Hong Kong and Japan – it is expected to issue about 60 percent of the total forecast global sukuk volume of $44 billion in 2012. In fact, a $10 billion sukuk was issued this January by PLUS Expressways Berhad, a Malaysian toll expressway operator. Meanwhile, in Indonesia, the sukuk market is projected to double in 2012 from $1.9 billion last year. The Indonesian government has already sold $1.5 billion of local sukuk, and is likely to issue up to another $1.5 billion in the second half of the year, according to HSBC.
Such robust markets exacerbate the struggle for emerging players. For example, Malaysia offers additional incentives to issuers of Islamic bonds, making this a more lucrative option. So, could Hong Kong, for example, offer similar incentives on its Islamic bonds? It is not beyond the realm of possibility, states Man. “But at the same time,” he adds, “what Hong Kong has tried to do is level the playing field so it is even for both conventional and Islamic financing. So, there might be a reluctance to try and create an unlevel playing field the other way.”
The right direction
The exponential growth of Islamic finance is certainly tempting. But it has not been easy for the newcomers in North Asia – Hong Kong and Japan have yet to make a dent in the market. For its part, South Korea too has made no headway. Multiple attempts to pass a bill to attract Islamic finance have been shot down in parliament by special interest groups, most recently in February 2011. Nonetheless, Hong Kong and Japan’s actions are seen as a positive step in the right direction. “A lot of countries have certainly mentioned changes in the past, but how serious they are remains to be seen. It is fair to say that Hong Kong and Japan have taken the most proactive steps, certainly in North Asia,” says Man. Barzilai agrees: “I do believe it is going to be a niche market for North Asia,” he says. “Even as we see the Hong Kong government develop laws, we‘ve seen Japan open things up, so it shouldn’t be long before someone is lined up for a sukuk.”
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