Indonesia Sukuk: The long road to success

Indonesia has the biggest Moslem population (~226mil) in the world. In comparison Malaysia’s Moslem population stands at 18mil.Yet Malaysia continues to maintain its position as an international Islamic financial hub - a center of origination, issuance and trading of sukuk (see Fig 1). Islamic finance is a distinctly Malaysian affair.

Fig.1¹: Global sukuk market – trend and market share

Indonesia’s first corporate sukuk was sold in 2002, more than a decade after the first corporate issue in Malaysia. In absolute terms, Indonesia's total outstanding corporate sukuk was around USD1 billion at the end of 2017, while the Malaysian equivalent exceeded USD100 billion.

A comparison of the value of Indonesia's and Malaysia's corporate sukuk markets highlights the huge gap between them. Since 2014, outstanding sukuk in Malaysia has surpassed outstanding bonds by more than half, and the percentage has been rising steadily as the quasi-government and corporate sectors have been opting to issue sukuk instead of conventional bonds. The Indonesian corporate sukuk market remains domestically-focused with almost all sukuk issued in Indonesian Rupiah.

One would naturally assume that the higher the percentage of Moslem in a country, the higher the demand for Sharia-compliant securities. But Indonesia is evidence that it will take much more than a big Moslem population for the sukuk market to thrive. Indonesia can learn from Malaysia’s experience and develop its own Islamic capital markets much more quickly.

Indonesia has been building a regulatory framework for Islamic finance but is yet to address the key point required for the sukuk to become a sustainable financing tool, that is, the distinction between beneficial and legal ownership.

Beneficial ownership is when a person or entity enjoys some of the benefits of property rights without holding the legal title of the property. Beneficial ownership is essential in Islamic structures where investors can take advantage of the economic benefits that the asset offers – even when they do not hold that asset’s legal title.

In the basic structure of a sukuk, the originator establishes a special purpose vehicle (SPV) and issues the sukuk through that SPV to raise funds from investors. Under a trust arrangement, the SPV purchases the asset as a trustee and declares a trust over the sukuk assets in favour of the beneficiaries (sukuk holders/investors) that have beneficial rights over the assets, entitling them to receive cash flow from the assets. The trust assets hence comprise the underlying assets as well as the related rights and obligations.

Common law² jurisdictions such as Malaysia recognise the concepts of trust and beneficial interest, which determines the essence of Sharia contract. Civil law code³ jurisdictions like Indonesia do not recognise the separation of legal and beneficial titles; they only acknowledge ownership held by one party.

Furthermore, the Indonesian sukuk structure appears to be suboptimal; corporate issuers mainly use ijara (lease agreement) and mudaraba (partnership), as approved by the National Sharia Board. The ijara contract is the preferred option as this structure utilises underlying assets in the form of fixed tangible assets or projects. This can be a challenge for firms planning to raise money for new projects as their assets may not be immediately available or worse, not even built.

In contrast, Malaysian corporates utilise the murabaha, a scheme used for purchasing equipment and products. It involves a straightforward sale-and-purchase contract that stipulates the cost and profit and is popular because of its implementation ease and there being no requirement for issuers to utilise existing assets.

Recognising the challenge, the Indonesian government passed a law in 2008 that allows the government to issue sukuk through a state-owned special purpose vehicle company, Perusahaan Penerbit SBSN (Sovereign Sukuk Issuing Company) which then led to more successful Islamic funding at the government level. It now needs to pass legislation that will enable corporate issuers to use the same beneficial ownership framework.

Fig 2⁴: Sukuk structure makes a difference

Taxation parity between sukuk and conventional bonds is key for the former to take off. In practice, a sukuk transaction necessitates multiple asset transfers from the SPV to the entity seeking to raise finance (the originator). Each transfer may result in additional tax liability that will put the sukuk at a severe disadvantage relative to conventional bonds. In Indonesia, each time a transfer occurs, value added tax is triggered according to the interpretation of VAT Law of 2009.

Without special tax provisions for sukuk, there is a considerable tax burden for issuers, making it less attractive for corporates to issue sukuks. Interestingly, in Malaysia, rather than creating a level playing field, the country’s tax code favours sukuk issuers over conventional bonds, further entrenching Malaysia’s aspiration of becoming a vibrant sukuk hub.

Fig 3⁵: Indonesia’s nascent sukuk market

Source: Asianbondsonline.ADB.org

Aside from the legal and tax framework, the Indonesian government can take a number of steps to promote sukuks.

For one, institutional investors such as local pension funds and life insurance companies should be encouraged to invest in sukuks given that the biggest portion of their investments are still in time deposits. That long-term assets such as sukuk are appropriate investments for institutional investors needs to be impressed upon them. Education therefore plays an important role; investors should be shown the benefits of purchasing sukuks to fulfil their asset-liability management needs.

Another avenue is to specifically target key sectors. The majority of corporate sukuk issued in Malaysia, for example, is in financial service and the infrastructure sector (combining power generation, utilities, transportation and telecommunication). Similarly, infrastructure projects can eventually be a key source of sukuk issuance in Indonesia due to their asset related nature. In fact, the government’s ambitious infrastructure plan can become the biggest enabler in creating a corridor for Indonesia’s sukuk growth.

In this regard, the government could explore sukuk programmes directed specifically at religious funds (such as hajj or pilgrimage fund) that are linked to finance the infrastructure projects. The Hajj Fund Management Agency (BPKH) which was established in 2017, should actively manage these funds by selecting more profitable, yet sharia-compliant investment instruments. The fund currently has USD 7.1 billion, of which 60% sits in time deposits and the rest in government sukuk.

Pushing the Hajj fund to broaden its investment universe alone may not be sufficient in the long-run as Indonesia needs a diversified group of investors to support these initiatives. It comes down to the policymakers to develop this culture through educational programs.

All said, the sukuk landscape offers a huge opportunity for the Indonesian government to provide clear leadership and effect top-down legal and tax incentives to ensure the sukuk becomes a feasible corporate financing instrument.