With 200 million Muslims, more than in any other country, Indonesia is still struggling to make a success of Islamic finance, which it could use to raise money for much-needed roads, ports and power stations.
Reasons for that underperformance go back two centuries.
In 1816, Britain ended its brief control of Indonesian territories and ceded them to the Netherlands as it had agreed to do once Napoleon Bonaparte was defeated.
While any manner of colonial rule is morally repugnant, from a purely economic perspective Indonesia was unlucky to become a Dutch colony and thus miss out on the common-law tradition that its neighbors Malaysia and Singapore got from the British. What has all this to do with Islamic finance?
A lot. Take a sukuk, or an Islamic bond. It’s the fastest- growing segment of the $700 billion Islamic finance industry. Moody’s Investors Service expects issuances globally will increase 30 percent to 35 percent this year compared with 2007.
Setting up a sukuk al-ijara — a popular, leasing-type product — requires the issuer to transfer the usufruct — or the beneficial ownership of an asset — to a special-purpose vehicle. The SPV pays the issuer by selling sukuk certificates to investors, who earn a share of the lease rentals rather than interest, which is prohibited in Islam.
In Indonesian law, there’s neither an explicit acknowledgement of usufruct nor formal recognition of a company set up purely as a financing vehicle.
Indonesia Versus Malaysia
How does one do sukuks in Indonesia then? There have been a few domestic, corporate sukuk issuances in Indonesia; however, a product that’s acceptable to global investors will need more legal clarity.
Contrast this state of ambiguity with Malaysia, a common-law jurisdiction where SPVs can be easily set up as trusts and where courts accept the difference between beneficial and actual ownership. In Malaysia, almost 13 percent of banking assets are compliant with Shariah, or Islamic law, compared with less than 2 percent in Indonesia.
Sukuk issuances trumped sales of conventional bonds in Malaysia last year. With no difference in taxation, highest-rated companies in Malaysia can save as much as 25 basis points by issuing sukuks instead of bonds.
Malaysian offerings are also becoming more sophisticated.
In March, Khazanah Nasional Bhd., Malaysia’s sovereign- wealth fund, sold a $550 million, five-year Islamic bond. The sukuk certificates issued by Khazanah are exchangeable into Hong Kong shares of Parkson Retail Group Ltd., China’s biggest department-store operator.
The reason Malaysia has done rather well in Islamic finance — and Indonesia hasn’t — has much to do with the flexibility of common-law institutions to accommodate innovation.
“The concept of `trust’ under the common law has facilitated the issuance of Islamic securities,” Zeti Akhtar Aziz, Malaysia’s central bank governor, said in a 2007 speech. “Some civil-law countries have enacted specific legislation to provide for the introduction of trust so as to align their legal systems with the requirements of Islamic finance.”
Qatar, a civil-law country like Indonesia, did this by setting up Qatar Financial Centre as a common-law jurisdiction. Indonesia is taking the longer route of changing the code.
Long-awaited legislation for sovereign sukuks was finally passed by parliament last month; after President Susilo Bambang Yudhoyono makes the new law effective, the Indonesian government may announce its maiden global offering of these securities. Malaysia, Pakistan, Qatar, Bahrain, the United Arab Emirates and Brunei already have sovereign sukuks.
More crucially, after the law is in force, there will be, for the first time in Indonesia, explicit sanction for both sale of usufruct as well as for the creation of SPVs.
The same principles will then have to be introduced, via another new law, for corporate sukuks. The existing legal code will have to be harmonized to accommodate the additions.
It’s a tedious process, but one that matters a great deal to investors. Indonesian companies have routinely floated SPVs in the Netherlands to raise conventional bond financing.
Yet, the validity of these structures came under severe doubt in November 2006 when the Indonesian Supreme Court nullified $500 million of bonds sold by a unit of Asia Pulp & Paper Co., Southeast Asia’s biggest defaulter, on the grounds that the offshore SPV used in the transaction was illegal.
Creditors were stumped.
It’s important for Indonesia to fix the legal status of financing arrangements related to sukuks in order to avoid a repeat of that earlier fiasco.
Indonesia needs $22 billion annually through 2011 for public amenities that would boost the capacity of the economy and allow it to grow faster than the average 5.5 percent pace at which it has expanded in the past five years.
Amid a global credit crunch, sukuks would be a great way to access a large pool of money at a reasonable cost. Indonesia mustn’t squander the opportunity.
The economic consequences of a country’s legal origins can be profound. Indonesia can’t go back in time and change where its laws come from, but with a little ingenuity and some foresight it may yet script a new future.