Islamic Finance on the Rise

Indonesia

Economic News

22 Jul 2010
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Despite being home to the world's largest Muslim population, Islamic finance in Indonesia has yet to catch up with other Asian financial markets, such as Malaysia, Singapore and Hong Kong. In order to increase its domestic penetration, as well as help the country attract more outside funding, the government is introducing new legislation to make sharia-compliant financial products more competitive.



According to figures from the Central Bank, there were 3.79m Islamic banking customers in Indonesia in 2008, accounting for approximately 3% of all banking assets. While the number of Islamic retail banking customers is extremely low for a population of 260m, the number of sharia-compliant banking outlets versus conventional banking outlets stood relatively higher at 1452 compared with 6500. The country presently has three fully-fledged Islamic banks, 25 Islamic divisions of conventional banks and approximately 110 rural Islamic banks. Indonesia is in fact said to have the largest number of Islamic financial institutions in the world, thus indicating that the low penetration is down to a lack of education among the public as to the benefits of Islamic banking.



The country had initially set out to increase the share of sharia banking assets to 5% of the total in 2009, but the consensus is that it will fall short of this target. In contrast, Malaysia's Islamic banking industry, which is considered to have more advanced and attractive legislation, accounts for 12% of its banking market.



Riawan Amin, the president director of Bank Muamalat, the oldest Islamic bank in the country, told OBG, "Malaysia started much earlier than Indonesia. They also have a much smaller population and their banking system was more advanced as a whole, so it is not really proper to compare the two. But Indonesia, with the largest Muslim population in the world, is the sleeping giant. Our sheer market size and growth potential cannot be ignored."



Mahmoud Abushamma, the country head for HSBC Amanah in Indonesia, echoed this optimism, explaining to OBG that, "Islamic banking in Indonesia is small, but you have to bear in mind how young it is. Malaysia has been into Islamic banking for over a decade, while technically Indonesia has only had dedicated Islamic banking legislation since last year. There are 250m people in the country, 90% of whom are Muslim, and even conventional banking is not yet saturated. So, while today it might seem small, the growth potential is considerable and it will not remain small for very long."



The past 12 months have seen the introduction of a number of new initiatives aimed at advancing the sector. The first was a new bill passed in June 2008 allowing commercial banks to convert their business into sharia-compliant banks, as well as an allowance for new foreign sharia banks to establish operations in the country in partnership with local entities. Identifying the tremendous market growth opportunity, most of the country's leading conventional banks have since launched or are applying to launch sharia-compliant units, while some prominent Middle Eastern Islamic banks have opened offices in the country.



In March 2009, the Central Bank issued four new laws governing Islamic banks that demonstrate its continued commitment to developing a sound legal and regulatory regime. These new laws are related to minimum reserve requirements, payments clearing, the creation of an Islamic interbank money market and the issuance of Islamic-compliant promissory notes to add liquidity to the sector.



While the new laws will go a long way to spurring the sector's immediate growth, structurally, the establishment of a single industry authority should provide the right framework and regulatory setting to ensure the acceleration of new regulations for a long time to come. Under the new sharia law, the Dewan Syariah Nasional, under the auspices of the Central Bank, will have ultimate authority over approval of what products and services qualify as sharia-compliant. This structure is similar to that of Malaysia's, and should eliminate the timely debates on Islamic interpretation that have slowed the development of Indonesia's Islamic finance in the past.



In addition to growing Islamic banking domestically, a primary motivation behind improved governance for Islamic finance is the desire to secure a greater share of the $700bn global Islamic finance market. In particular, the country is looking to attract funds from what is considered the world's most liquid investment region – the Middle East. Despite an extensive list of government and public-private infrastructure projects in need of external funding, Indonesia to date has not tapped the full potential of Islamic funding.



"The Middle East, while not immune to the global crisis, is one region where funds are still available. So Indonesia is opening itself to attract investment from the region, with new Islamic finance products playing a key part in the equation. Indonesia, at the same time, is one of South-east Asia's biggest and fastest-growing economies. Middle East investors are beginning to put Indonesia on their radar screen and are exploring specific investment opportunities. The timing for both parties is perfect," Abushamma told OBG.



At present, Islamic-compliant investment makes up only 2.3% of the country's bond market and it is hoped that with the changes in legislation, it could reach 5% of the total within two years. The government has announced that it is aiming to launch $1.5bn in global sukuk in the latter half of this year, following the successful sale of its first retail (domestic) sukuk in February, valued at $465mn. If the global sukuk proves as successful, this should provide the impetus for more corporations in the country taking the route of an international sukuk for fundraising as well.



To date, Indonesian corporations have issued approximately 20 sukuk, a relatively small figure. However, for corporate sukuk to capture its full potential, industry players would like to see the passing of a new corporate sukuk law that will introduce greater tax and cost neutrality to level the playing field with conventional corporate bonds. Most Islamic bonds involve a sale and purchase of assets, which results in double taxation over conventional securities. In addition, a further disincentive is that as the rules stand, Islamic bond investors are required to hold their bonds until maturity. By contrast, in Malaysia investors are not taxed twice and are also permitted to trade the bonds prior to maturity. The result in Malaysia is that sukuk are typically 5 to 30 basis points cheaper than Indonesia, with 50% of sukuk issuances taken up by commercial bond traders.



Overall, while Islamic banking is still in its infancy, given the size of the economy, the global hunger for Islamic-compliant investment and the fact that Indonesia is home to 10% of the world's Muslim population, through continued regulatory progress the country has the potential to transform into one of the world's most important Islamic finance markets.

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