In my last post, I wrote about some of the details of Islamic banking in Indonesia, which has been growing rapidly. One other area of the Islamic finance industry in Indonesia that is growing rapidly is government sukuk issuance. Sovereign sukuk in Indonesia grew 45 percent in 2010 to Rp 27.76 trillion ($3.2 billion) and has reached Rp 17.94 trillion ($2.1 billion) so far this year with a number of sukuk planned later in the year.
The growth in Indonesian sovereign sukuk has been helped by the economy weathering the financial crisis well, in addition to a strengthening of the Rupiah. The sukuk also pay a relatively high return (in local currency due to the country's 6.2% inflation rate in April) at the same time as the country's sovereign rating is improving, having been upgraded to BB+ by S&P in April, one notch below investment grade.
The growth in sukuk has come despite difficulties last year in successfully auctioning off some sukuk. Investors bid at yields higher than conventional bonds with similar maturities (up to 50 basis points higher), which were rejected by the Finance Ministry over concerns that higher rates on sukuk would lead to bond investors also demanding higher yields. However, from the perspective of the investors, it made sense to ask for higher yields on sukuk given their relative illiquidity compared with conventional government bonds. In response, the government considered using a book-building method to negotiate rates rather than the auctions, some of which failed to attract any winning bids.
One of the unique aspects of sukuk compared to conventional bonds is the use of an asset in structuring the sukuk. Most sukuk are asset-based, which means the investors are unsecured creditors and do not have legal recourse to the underlying assets (they hold only beneficial ownership over the underlying asset). With the rapid growth in government sukuk issuance, the Indonesian government has run out of assets to use for new sukuk. The director of Islamic finance at the Finance Ministry's Debt Management Office is quoted by Bloomberg saying "We've run out of existing buildings and land that's been approved". In response, the government has asked the House of Representatives to add Rp 30 trillion ($3.5 billion) of state-owned land and office buildings to the list of approved assets.
Bloomberg reports that if they are not successful in receiving approval for the additional assets, they will instead use cash flows from transport projects under construction to back a sukuk planned for issuance on May 31. This would replace the structure of the ijara (lease-based) sukuk that has been used almost exclusively. In an ijara sukuk, the building or land is sold (or beneficial ownership) is sold to the sukuk trust, which issues sukuk to pay for the acquisition. The trust then leases the asset back to the government and distributes the rental payments to sukuk investors. At maturity, the government repurchases the asset, providing funds to redeem the sukuk.
A sukuk that is based on cash flows from a project under construction would generally not be able to use the ijara structure because it is (generally) not allowable to lease an asset that does not exist yet. Usually, when financing is raised for construction of a project under construction, it would be done using a combination of istisna'a and ijara. Istisna'a financing is flexible in the payment terms so they can be structured to replicate the cash flow bond investors are looking for. However, istisna'a is considered a debt (i.e. if you provide financing under istisna'a, you have the right to future cash flows, not either legal or beneficial ownership of an asset until it is completed). That makes trading problematic because it can only be traded at par.
That is where the ijara aspect comes into play. As the construction reaches a point where the asset is usable, the asset is owned by the investor, who can lease it to the government (making the sukuk tradable at values besides par). However, if this type of sukuk is used, it could be problematic because investors would demand higher yields for the illiquidity in the istisna'a phase.
There may be other structures they could use besides the istisna'a-ijara sukuk that would avoid these problems, but it is not possible to say for sure what structure they are using. The debate will likely become moot (at least temporarily) if the House of Representatives expands the assets approved to back ijara sukuk.