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Tuesday, 26 June 2007

Tapping Indonesia's Islamic banking potential

(Asia Times, 26 June 07) JAKARTA - Indonesia is taking steps to ramp up its Islamic banking sector, which some financial analysts believe has the potential of creating the largest sharia finance area in the world. President Susilo Bambang Yudhoyono said at the recently completed World Islamic Economic Conference in Kuala Lumpur that his government intends to push through the regulatory change necessary to support the industry's development, which still only accounts for about 2% of total Indonesian banking activity. Sharia banking conducts modern business while adhering to Islamic laws regarding financial transactions. Nonetheless, the industry has grown rapidly in recent years, as banks tap deeper into one of the world's largest Muslim markets, where 87% of the country's 240 million people follow Islam. Worldwide, Islamic finance currently represents less than 10% of the total global Muslim market of 1.5 billion people. Some financial analysts believe, based on current market trends, that the global Islamic financial-services industry, including banking assets, could grow from US$1 trillion now to $2.8 trillion by 2010. US-based international credit-rating agency Standard & Poor's estimates that the global potential for Islamic financial services could be closer to $4 trillion. Much of that growth could come from Indonesia and its $300 billion dollar economy. In Southeast Asia, Indonesia still trails its smaller regional neighbor Malaysia, where the regulatory environment has already been modified to attract foreign Islamic investments. But financial analysts say there is huge potential in Indonesia to attract not only local money but also petrodollars and sharia-compliant funds from the Middle East, as has happened with Malaysia. Central to Islamic finance, which offers products and services akin to conventional financial products, is its "zero interest" concept and emphasis on profit-sharing. Based on sharia law, which forbids the collection of interest on loans and debts, including bonds, the system relies on asset-backed, contract-based, profit-sharing. For instance, so-called murabahah-based finance is concerned with lending for consumer goods such as motor vehicles and housing, but under the current regulatory regime is uncompetitive vis-a-vis conventional Indonesian banks. Sharia banks finance the purchases on behalf of a customer for an agreed fee, but these transactions incur a 10% value-added tax (VAT) because under current taxation laws such a fee is not categorized as interest, which would exempt it from VAT payments. Despite the regulatory hurdles, the industry is experiencing a mini-boom. Indonesia's first Islamic bank, Bank Muamalat, was founded in 1992 and has forecast that its profits will double year on year because of surging demand for its innovative, sharia-based Shar-E product. Last year nearly 664,000 customers applied for its Shar-E products, surging from the 132,669 customers it had in 2005. As of the end of 2006, Bank Muamalat had been joined by 23 other Islamic banks and 456 conventional bank branch offices that provided sharia banking services. According to Bank Indonesia, the central bank, the share of sharia banking assets of total national banking assets was a mere 1.6%, up slightly from the 1.4% recorded at the end of 2005. Yet Islamic banks reported a 79% year-on-year increase in business volume in 2006, to Rp8.76 trillion ($1.36 billion). The amount of leasing business, known as ijarah, grew by a whopping 164.7%, and sharia mutual funds grew in asset value by 17.6% last year, with a total net asset value of about Rp663.7 million. By the end of last year, there were about 20 sharia funds, representing about 5% of Indonesia's total number of mutual funds but only 1.3% of the industry's value. At least 17 companies listed on the Jakarta Stock Exchange have issued sharia-compliant bonds, representing 10.5% of the total number of listed companies that have issued debt instruments, with a total issuance value of Rp2.2 trillion. Increasingly, Indonesian banks are not only looking to add Islamic products to their loan portfolios, but are sounding out possible acquisitions to enhance their Islamic banking potential. For example, Bank Central Asia (BCA), Indonesia's second-largest lender by assets, plans to buy two small banks, and one of the acquired institutions would be transformed into a fully sharia-compliant lender. (BCA is 74% owned by a consortium of Singapore's state-run investment arm Temasek Holdings.) The only foreign bank currently licensed to conduct Islamic banking in Indonesia is HSBC, which offers Islamic banking services through its HSBC Amanah Syariah unit. Last month the unit arranged a $50 million international sharia financing syndication for state-owned Krakatau Steel, Indonesia's biggest steel producer. That followed on two previous deals it arranged for state-owned oil-and-gas company Pertamina to tap the global Islamic finance market, including a $322 million Islamic international syndicated loan in 2004 and a similar $200 million deal in 2006. Still, the lack of sharia-friendly regulations has, in places, held the industry back. According to Jakarta's governor, Sutiyoso, the lack of clear rules and regulations for sharia finance was behind the decision by a Dubai-based Islamic Bank consortium to shy away from funding Jakarta's multimillion-dollar monorail project. The consortium had agreed early this year to invest provided that the central government and the city administration would guarantee to cover half of any potential losses incurred by the project's operations. Sutiyoso managed to get the guarantees in place by April, but the sharia deal nonetheless proved to be incompatible with current Indonesian law. Government planners hope that regulatory change will pave the way for both government enterprises and private corporations to attract Islamic investors worldwide through the issuance of Islamic bonds. Toward that end, three draft laws related to sharia banking, tax and securities transactions are expected to be enacted this year. And they are looking to Malaysia's recent successful experience, particularly in relation to Malaysian corporations' issuances of foreign-currency-denominated Islamic bonds. Malaysia also gives tax breaks to foreign banks that set up Islamic finance operations, and several Persian Gulf-based Islamic banks have recently been awarded licenses to open branches there. Once Indonesia's new sharia-friendly laws come on line this year, Islamic banking could provide a valuable new source of foreign investment for Indonesia as well.

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