Islamic finance in Asia is a distinctly Malaysian affair. Indonesia, an emerging regional powerhouse with the world's biggest Muslim population, does not even figure. Indonesia needs to address this shortcoming. Islamic finance could help it solve two of its biggest financing challenges: funding infrastructure and reducing its dependency on foreign borrowing.
The prospect is especially tantalising because Indonesia is in a position to learn from Malaysia's experience and develop its own Islamic capital markets much more quickly. It could even exploit the deep liquidity pool that Malaysia has built.
Take infrastructure. Indonesia plans to spend US$200bn on infrastructure between now and 2014. Progress, however, has been slow.
Indonesia has been clearing the legal obstacles. It was a long time coming, but the country recently passed laws that allow the government to acquire forcibly land that has been earmarked for infrastructure projects - long thought to be the biggest legal hurdle to the infrastructure build-out.
The other hurdle is figuring out where the money is going to come from. Infrastructure finance requires long tenors, and Indonesia's banks - though very well capitalised - are facing strong regulatory pressure to shorten lending maturities in accordance with Basel III requirements. Foreign banks are facing the same issue, on top of lending crises in their home markets, so are in no position to fill in that gap.
Islamic finance, however, could step into the breach. Like project financing, Islamic bonds - or sukuk - are asset-backed or asset-based structures, making them well-suited to financing infrastructure.
Malaysia has used sukuk to fund infrastructure projects ranging from ports and airports to roads and bridges. More than 40% of all sukuk originated in Malaysia are destined for infrastructure finance.
Indonesia has been building a regulatory framework for Islamic finance but is yet to make the key change required for sukuk to become a viable project financing tool - the distinction between beneficial and legal ownership.
Beneficial ownership is when a person or entity enjoys some of the benefits of property rights without actually holding legal title to the property. Beneficial ownership is essential in Islamic structures where investors, instead of earning interest, gain income derived from an asset - even when they do not hold that asset's legal title.
Indonesia clearly understands the importance of recognising beneficial ownership, because the sovereign's two global sukuk have involved selling the beneficial interests to certain properties. It now needs to pass laws that will allow domestic issuers to use the same beneficial ownership framework.
As well as financing infrastructure, a domestic sukuk market would also help Indonesian corporates reduce their dependency on foreign borrowing.
Ever since borrowing too much short-term dollar debt in the run-up to the Asian financial crisis 15 years ago, Indonesia has worked hard to develop a local currency debt market. The rupiah bond market has had one of its busiest markets ever this year, printing Rp45.5trn (US$4.8bn) of bonds so far. But that still pales in comparison to Indonesian bond issuance offshore, which stands at US$9.2bn year to date. The development of a sukuk market could help address this imbalance.
About 210m of Indonesia's 240m people are Muslims, creating a large pool of natural demand for Islamic finance products. It is the government, however, that needs to provide the top-down part of the equation in the form of the necessary regulations and tax incentives that will ensure Islamic finance becomes a viable option.
Indonesia also lacks the large pool of liquidity that Malaysia's pension funds provide, and that is another area for government action. But Indonesian sukuk issuers would at least be able to tap Malaysia's pool of money almost immediately - much as Middle Eastern issuers are already doing.
Malaysia is the world leader in Islamic bonds, and its geographic, cultural and linguistic proximity to Indonesia - the very thing that leads to arguments over the heritage of traditional dances and costumes - is something that should make replicating its Islamic finance prowess easier. If it becomes a success, no one will care whether it was home-grown or not.
(Reuters / 19 Sep 2012)
Alfalah Consulting - Kuala Lumpur: www.alfalahconsulting.com
Islamic Investment Malaysia: www.islamic-invest-malaysia.com