National Islamic Finance Committee

Funding Infrastructure Development through Islamic Finance: Issues and Challenges

National Islamic Finance Committee 1

Ronald Rulindo, Ph.D. (Director of Islamic Finance Product Innovation, Financial Market Deepening and Infrastructure Development of KNKS)

Delivered on BI-ADFIMI-KNKS joint CEO seminar on “Islamic Structured Finance: Cases of Infrastructure Project Finance in IsDB Member Countries”

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National Islamic Finance Committee is established to enhance the impact of Islamic finance on national economic development

EXECUTIVE MANAGEMENT

STEERING BOARD

CHAIRMAN

VICE CHAIRMANCatalyst of

Islamic economic

development in Indonesia

Functions

Coordinate the

Stakeholders

Create Policy and Strategy

Recommendations

Monitor and Evaluate

Provide Solutions

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01 The need for infrastructure development

02 Islamic Finance and Infrastructure Financing

03 Funding Infrastructure through Islamic Finance: Case of Indonesia

01The need for infrastructure development

Agenda

Komite Nasional Keuangan Syariah

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Global infrastructure spending trends shows continuous improvement in terms of budget allocation across countries, dominated by electricity and road sectors

Source: Oxford Economics

Billion US$, based on 2015 prices and exchange rates

Global infrastructure spending, 2007-2040 Average annual investment by sector, 2007-2015

35%

29%

12%

12%

8%

2% 2%

INVESTMENT BY SECTOR

Electricity

Road

Telecoms

Rail

Water

Port

Airport

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How can the world bridge its infrastructure gap other than government spending?

Source: McKinsey Global Institute

The world invests $2.5 trillion annually in transport, power, water, and telecom as of today

The world needs to invest $3.3 trillion annually just to meet growth forecast by 2030Find a way to attract

more alternative financing sources

$120 trillion fundsunder management of

Banks

Investment Companies

Insurance

Public & private pension

Sovereign wealth funds

Endowment &

Foundations

Infrastructure & private

equity funds

Unlock flow of finance

To Improve Productivity

of Infrastructure

Investment

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The State of Infrastructure Investment in OIC Member Countries varied from one to another

Source: https://infracompass.gihub.org/compare_countries. COMCEC OIC

9.8%

13.9%

14.7%

14.8%

17.8%

19.3%

20.7%

21.0%

23.8%

26.4%

37.1%

46.0%

0.0% 5.0% 10.0% 15.0% 20.0% 25.0% 30.0% 35.0% 40.0% 45.0% 50.0%

Total Infrastructure Investments Contribution towards GDP(Total Infrastructure Investment - %GDP)

MOROCCO SENEGAL GUINEA NIGERIA

INDONESIA BENIN SAUDI ARABIA MALAYSIA

COTE D'IVOIRE EGYPT TURKEY TUNISIA

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Infrastructure spending needs and the funding gaps in several OIC Countries years ahead demonstrated the demands for more investments

Source: GIH and Oxford Economics (2018), Global Infrastructure Outlook, Infrastructure investment needs 50 countries, 7 sectors to 2040. COMCEC OIC

80

81

100

246

292

460

480

608

613

675

878

975

1712

61

63

92

210

208

383

355

417

499

445

657

569

1642

0 200 400 600 800 1000 1200 1400 1600 1800

SENEGAL

JORDAN

AZERBAIJAN

MOROCCO

KAZAKHSTAN

MALAYSIA

PAKISTAN

BANGLADESH

TURKEY

EGYPT

NIGERIA

SAUDI ARABIA

INDONESIA

Infrastructure Spending Needs 2016-2040 Cumulative in Selected OIC Countries (USD billion, 2015 prices and exchange rates)

2016 - 2040 Current Trend 2016 - 2040 Investment Need

818 19

36

70 77 84

114125

191

221 230

406

Infrastructure Gap in Selected OIC Countries 2016-2040 (USD billion 2015 prices and exchange rates)

Gap Amount

Total Investment Needs till 2040:

US$ 7,200

Total Infrastructure Gap

till 2040: US$ 1,599

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Islamic Finance sector size and investment allocation in infrastructure sector

Source: ICD – IsDB, Thomson Reuters (2017)

1,589.0

42.5124.4

344.8

91.2

US$ (2016)

Global Islamic Financial Sectors Size (USD billion & Percentage)

Islamic Banking Takaful Other IFIs Sukuk Islamic Funds

Total Value of Islamic Financial Industry: US$ 2,438 billion

72.6%

1.9%

5.7% 15.7%

4.1%

SectorsTotal assets

(USD billions)

Percentage going to

Infrastructure

Infrastructure Investments by

Islamic Finance (USD Billion)

Islamic Banking

1,598.90 4.74% 75.8

Takaful 42.5 2.00% 0.9

Sukuk 344.8 11.57% 39.9

IDB Project Financing

3.12

Total 119.7

Total Islamic Finance Investments in Infrastructure Sector (2017-2018, USD Billion)

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01 The need for infrastructure development

02 Islamic Finance and Infrastructure Financing

03 Funding Infrastructure through Islamic Finance: Case of Indonesia

02Islamic Finance and Infrastructure Financing

Agenda

Komite Nasional Keuangan Syariah

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Islamic finance befitting for Infrastructure Project

Source: World Bank, IsDB

Returns should be linked to the profit/earnings and derived from commercial risk taken by financier

Islamic financiers become partners in the project

Transactions should be free from speculation or gambling (maysir)

Existence of uncertainty in a contract is prohibited

Investment relating to prohibited goods and activities are not permitted

Infrastructure projects allow risk to be shared among the parties involved in the project, including financiers (in PPP)

Infrastructure projects allow Islamic financiers to become a party to the project, not only as a lender

Infrastructure projects, by nature, should be free from speculation or gambling

Project contracts are generally well defined with certainty

Infrastructure projects mainly exclude the areas of the prohibited goods

Principles of Islamic Finance Infrastructure Project

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Islamic finance contracts vis-à-vis conventional for infrastructure financing

Conventional and Islamic Finance Contracts for Infrastructure Financing

Contract Categories

Conventional Finance Islamic Finance

Equity

Equity provided by sponsors (ownership shares in the SPV)

Equity provided by sponsors (ownership shares in the SPV) —can take the form of musharakah or mudarabah

Infrastructure Equity fundsInfrastructure equity funds—the fund manager works as an agent (wakil) to manage the funds

DebtLoans with interest Sale-based instruments (murabahah

and istisna)Interest-based bonds

Hybrid

Various structures such as convertible bonds, preferred shares, mezzanine financing, etc.

While certain features such as convertibility of debt to equity are allowed, other structures such as preferred shares are not permissible.

Structures combining various contracts such as istisna-ijarah, wakala-ijarah, etc.

Islamic Finance Contracts for Project Financing

• Partnership financing method in which all parties jointly contribute and bear losses

Musharakah

• Profit and loss sharing-contract based

Mudarabah

• Manufacture or build assets based on terms specified by the buyer, at agreed price, within a certain time

Istisna

• A lease for a specific rent for a specific period

Ijara

• Agency contract whereby a principal appoints an agent to perform an act on its behalf

Wakala

Source: COMCEC OIC, Chu and Muneeza (2019)

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Project financing and implementation of Islamic finance contracts for Infrastructure PPP Projects

Source: World Bank, IsDB

Note: EPC = engineering, procurement, and construction; SPV = special purpose vehicle; O&M = operations and maintenance

Islamic finance

instruments

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Possible challenges of Islamic project financing implementation in infrastructure projects

Source: Rarasati et.all (2019), EDP Sciences.

01Understanding of Islamic financial transactions

(contracts, shariah structure & compliance)

02Financial institution capability in conducting project

finance

03Investor behavior and characteristics (risk and return

appetite)

04 Government policies and regulations

06Mismatch in the duration between Islamic finance

transaction maturity and infrastructure project

financing need

07 Project preparation and readiness (Feasibility studies)

08 Financing scheme and process

09 Understanding of infrastructure project financing

05

Government support, guarantee and commitment

(incl. incentives and level playing field for Islamic

finance-related projects)

10 Cost of Islamic finance fund (source of fund)

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01 The need for infrastructure development02 Islamic Finance and Infrastructure Financing03 Funding Infrastructure through Islamic Finance: Case of Indonesia

03Funding Infrastructure through Islamic Finance: Case of Indonesia

Agenda

Komite Nasional Keuangan Syariah

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Demand of infrastructure financing in Indonesia

Private Sector2,707

42%

State-Owned Enterprises

1,353

21%

Government Budget2,385

37%

INVESTMENT TARGET 2020-2024 Rp6.445 trillion

(trillion Rp)

Lack of managerial skills of project owner

Insufficient state and regional budget

Increasing level of government debt

Increasing debt to equity ratio of

the industry

ISSUES

Source: National Development Planning Agency

Source of Fund?

Current issue in

State-owned Companies

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Infrastructure financing from Islamic financial intitutions

Source: OJK and Ministry of Finance, 2019

Infrastructure financing from Islamic banking and capital market is increasing.However, the size of infrastructure financing from Islamic bank in Indonesia is lower than Islamic capital market (Sukuk).

46.25

91.89 91.80 104.51

148.25

-

20.00

40.00

60.00

80.00

100.00

120.00

140.00

160.00

2015 2016 2017 2018 Oct-19

Surat Berharga Syariah Negara (SBSN) Project Based Sukuk Issuance

(trillion Rp)

11.19

14.44

22.2024.65

28.53

0.00

5.00

10.00

15.00

20.00

25.00

30.00

2015 2016 2017 2018 Jun-19

Financing to Construction Sector by Indonesia’s Islamic Banking Industry

(trillion Rp)

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Advantages of using Islamic financial products/schemes for corporations

Public demand for sharia compliant transaction is increasing

Uniqueness of sharia compliant products that could address specific financial requirements and financing diversification

Several support and incentives from the government have been given to the Islamic finance industry

Investor diversification from local and international

Source: PT Bank Permata Tbk, with adjustments

• Anti Riba Movements• Critics on Debt

• Partnership• Sale and Lease Back• True Sale• Blended Finance

• Tax incentives on murabahah financing transactions

• Lower cap of sukuk issuance fee

• Listed in sharia index stocks• Wider access to Middle-Eastern/Islamic

investors• Wider access to green/impact investors

ADVANTAGES SUPPORTING FACTS

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Implication of Islamic financing schemes on Public Private Partnership

Unlike in conventional system where the price of lending money is interest rate, in Islamic financial system, money is not treated as a priced commodity. Every transaction should have real underlying assets and the contracts/’aqad used are specialized based on the transaction characteristics.

Conventional Loan

Murabahah and Istishna financing(Sales contract)

Mudharabah and Musyarakahfinancing

(Partnership contract)

Ijarah financing(Leasing contract)

Businessmodel

Loan/credit Bank/financier builds the asset (eg. housing, infrastructure projects) before transfering the ownership to the government/private sector entity.

After the construction, the asset could be refinanced through KIK EBA

Bank/financier and the private sector entity will establish a partnership to build the asset.

Leasing of assets with purchase options (eg. housing, infrastructure projects)

Accounting treatment

Bank records interest income and asset

Customer records interest expense and liability

Bank/financier book the asset as inventory (including during construction) before selling it to government/private sector entity.

Customer do not need to book the asset before the purchase and after the purchase it could be securitized (off balance sheet)

Asset during construction will bebooked as inventory by the bank.

After the construction, the asset could be refinanced through KIK EBA so Badan Usaha do not need to book as liability

Assets are booked by lessor (bank/financier).

Lessee (government/private sector entity) records rental expense in income statement, not booked as a liability

Taxation Refer to accounting treatment

No VAT charged in asset ownership transfer in murabahah financing

Income tax for investors of profit and loss sharing product is lower than income tax for deposit investors

No VAT charged in rental payments and sale of assets at the end of leasing period

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Sukuk Musharakah – IMFD (off-balance sheet) for alternative infrastructure project financing scheme

Source: KNKS

State-owned Company

Subsidiary

Islamic SPC

1

1

3

Third Party

4

5

6

6

Infrastructure Project

4Investor

2

Note: SPC = Special Purpose Company

1. Establishment of an Islamic Special Purpose Company

(SPC).

2. The Islamic SPC issue Sukuk Musharakah to the

investors, the proceeds recorded as the Temporary

Shirkah Funds at the Islamic SPC.

3. The State-owned Company orders the project to the

Islamic SPC with Ijarah Maushufah Fi Dzimmah –

upfront leasing (in Ijarah Muntahiyyah Bi Tamlik-

financial lease) and pay the rent.

4. The Islamic SPC orders the construction of the project

to the third party with Istishna’, and then the SPC

delivers to the The State-owned Company.

5. The Islamic SPC disbursed the profit to the investors.

6. At the maturity, the Islamic SPC execute purchase

undertaking of the investor’s portion (the principal).

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Islamic Close-ended Funds as an alternative source of infrastructure project financing (for State-owned Companies)

Source: KNKS

Supporting agents:1. Arranger2. Legal Counsel3. Tax & Financial

Counsel4. Rating Agency5. Auditor6. Islamic finance

experts

Infrastructure Projects

State-owned Company 1

Investors

Islamic Close-ended Funds (SPV)

2

2

3a

3b

3b

6

4

Custodian & Trustee

5

7

1 : Project indetification by the state-owned company

(originator) as the underlying for the issuance of Islamic close-

ended funds

2 : Appoint Asset Manager to create Islamic close-ended funds

(specified for infrastructure; based on the underlying project;

inviting investor’s participation,

3a : The funds disbursed the collected proceeds to the the

state-owned companies .

3b : The state-owned company or their subsidiary issue

common shares to the funds.

4 : Paying out dividen to the Custodian & Trustee.

5 : the Custodian & Trustee deliver dividen to the funds.

6 : The funds disbursed to the investors.

7 : At the time of funds dissolvent, the originator undertake

shares’ buyback at par.

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Assets Liabilities

Cash Deposits

Financing Profit-Sharing Investment Account (PSIA)

Underlying Asset SRIA (Specific Financing) Investment Account SRIA

Other Assets Equity

Total Asset Total Liabilities and Equity

Islamic Banks

Islamic Bank’s balance sheet illustration when implementing SRIA for Islamic PPP

Islamic Public Private Partnership

Global Investors

Government GuaranteePT Penjaminan

Infrastruktur Indonesia

The Islamic Corporation for the Insurance of Investment

and Export Credit

Islamic PPP Guarantee Facilitator

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Conclusion

Islamic financial industry is

relatively new and still facing various

challenges

However, it has a huge potential in contributing to

Indonesia’s infrastructure development

Government of Indonesia

continues to encourage Islamic financial industry’s

contribution to infrastructure development

We are open to collaborate with various stakeholders with relevant expertise and interest in supporting infrastructure development through Islamic finance

National Islamic Finance Committee

Thank You

National Islamic Finance Committee 23