While Islamic banks have steadily increased exposure to Gulf project financings over the last several years, they have often been the also ran in funding line ups, which tended to be dominated by conventional banks. Now, as a result of the ongoing financial crisis, the dramatic pullback by the latter provides them with the opportunity not only to help fill a funding gap, but in so doing put their own stamp on project finance. There were and still are constraints. But it is to the benefit of the Gulfs project sponsors that these be overcome to unlock this growing pool of liquidity, reports Melanie Lovatt from the Jacob Fleming Islamic Project Finance 2009conference, held in Dubai on 16-17 February.
Islamic banks have gradually taken a more prominent role in funding the regions projects (see table and MEES26 February 2007, and 4 April 2005), but while Islamic tranche size has increased, the Shari'a compliant component is comparatively minor, with a few notable exceptions by conventional bank and ECA financing. It is a misconception that the Islamic sector has not been impacted by the crisis by necessity of its Shari'a compliance its activities are rooted in the real economy and therefore asset-based funding, and asset quality has deteriorated across the globe. However, it is a nascent industry and market penetration is relatively low, so experts still anticipate strong growth, both in the Muslim world and even in countries where bankers want to serve large Muslim populations, such as the UK.
Islamic bank assets have been growing by 15% annually and according to informal numbers it is twice this figure, with deposits and financial assets expected to double in 2010, Assistant Secretary General of Zamel Consultation and International Islamic Economic and Financing Organization, Yusuf Al-Zamel, told delegates. Saudi Arabia for example, has seen the ranks of its Shari'a compliant banks expand, with the latest, Al-Inma, established as recently as last year, and a number of conventional banks in the Kingdom and wider Gulf have had Islamic makeovers. These banks could represent a growing source of liquidity for GCC sponsors which are currently facing delays in implementing projects due to difficulties in securing conventional financing.
To become a more accessible source of funds for project finance, Islamic banks need to undergo changes, while at the same time so do project finance structures in order to accommodate them, say project advisors. Thus far in project finance Islamic tranches have been dominated by Islamic windows of commercial banks because they had been the main source of liquidity. As a result, structures have focused on these players, rather than being aimed at bringing in Islamic banks. They had not really generated much extra liquidity, with the exception of the Saudi market, remarks Dolan Hinch, Deutsche Banks Director, Project and Capital Advisory Dubai. They were robbing Peter to pay Paul via Islamic windows, basically taking commercial bank debt, putting in an Islamic structure and not getting much out of that, he told delegates. Tellingly, only 15% of total Shari'a compliance demand is supplied by Islamic financial institutions, notes Dr Zamel.
Key Islamic GGC Project Financings, 2001-07 ($Bn)
Total | Islamic | Total | Islamic | ||||
Project | Country | Financing | Tranche | Project | Country | Financing | Tranche |
Marafiq | S Arabia | 3.315 | 0.600 | Bapco | Bahrain | 1.01 | 0.330 |
Shuqaiq | S Arabia | 1.280 | 0.112 | Sohar Ali | Oman | 1.46 | 0.240 |
Yansab | S Arabia | 3.500 | 0.850 | Dolphin | Qatar | 3.45 | 1.000 |
PetroRabigh | S Arabia | 5.800 | 0.600 | Qatargas 2 | Qatar | 4.50 | 0.530 |
Al-Waha | S Arabia | 0.631 | 0.525 | Umn Al Nar | UAE | 1.77 | 0.250 |
Kayan | S Arabia | 6.000 | 0.900 | Al Hidd | Bahrain | 0.26 | 0.050 |
Shuaiba | S Arabia | 1.200 | 0.200 | Shuweihat | UAE | 1.30 | 0.250 |
Taweelah* | UAE | 0.541 | 0.150 | Equate | Kuwait | 0.90 | 0.200 |
Source: HSBC, MEES.
* A2 Refinancing.
Square Peg, Round Hole
This has led to reactive rather than proactive structures, and a focus on conventional banks as the largest providers of liquidity, comments HSBCs Head of Project Finance Execution, MENA, Jonathan Robinson. There has been a disproportionate amount of time by banks, developers and lawyers, spent trying to squeeze this square peg into a round hole. Ultimately it is an unnatural fit for conventional lenders, defeating for many Islamic lenders and creates overly complex structures and a massive price disparity, he said, referring to the difference in the underlying risk profile of Islamic versus conventional financing. Although there has been some improvement in reducing costs and documentation, more progress is needed (MEES, 26 February 2007).
As a result of the pullback of conventional lenders, this is an opportune time in project finance to revisit the basic principles that are supposed to underpin Islamic financing, Mr Robinson said. This means revisiting structures so we end up with truer Islamic financing and recognition that there is different risk and compensation for that, he explained, noting that this will open up a market for the purer Islamic providers. The Secretary General of the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI), Muhammad Nedal Alchaar, also suggests that fundamentals be re-examined. He complains that that there is innovating into contracts, rather than innovating the contract itself, which has overly complicated Islamic finance. I hope these exotic deals will cease to exist. We do not have to mimic conventional systems, he explained. Furthermore, there are many Shari'a compliant structures beyond the typical ones often used for project finance (such as the Istisna'a during construction and Ijara thereafter) which have not been widely tapped, remarks Mian Muhammad Nazir from Dar al-Shari'a/Dubai Islamic Bank.
Other Major Constraints Tenor, Geography, Liquidity
Another key constraint to greater participation by Islamic banks, in addition to the low margins and thus low returns for financiers that characterized Gulf project finance in 2004-07, is the long tenor of deals, which typically extend to 15 years in the hydrocarbon sector and have stretched out over 20 years in the power industry. Islamic banks, and also conventional banks located in the region, tend to source funds from shorter term sources, such as deposits, and find it difficult to lend across long tenors due to a well-documented assets-liabilities mismatch. However, as a result of the current crisis, international banks are also unable to lend at the record breaking margins and tenors which had become commonplace, and the resultant changes will make deals more palatable to Islamic banks.
Currently being proposed by conventional market players are shorter-tenored structures such as mini-perms, which already prevail in long term infrastructure projects in Australia. If they take hold it may well be that there is a tenor and price alignment that starts to match some of the Islamic liquidity, suggests Mr Hinch. Conventional lenders typically access longer-dated funding through the bond market, although for Islamic banks, the sukuk (Islamic bonds) sector needs to undergo further growth and development before it can effectively fulfill such a role. Sukuks have typically been confined to 5-7 year tenors, however mini-perms could possibly hit this sukuk sweet spot proposes Mr Hinch. The shrink in project size, as sponsors downsize and also seek to construct larger projects in phases rather than in one go, will also more closely align sponsors needs with the capabilities of Islamic banks in liquidity terms.
While bonds themselves have been used in project finance, including in the Gulf for a number of Qatari LNG and LNG shipping deals, the project sukuk market has yet to take off and markets like this that are in their infancy should never be plan A for project sponsors, warns Mr Robinson. They face the same problems as traditional bonds in their use for project finance, such as negative carry during the construction period; but as the sector broadens, and a secondary market develops, tenors could be pushed out and they may become an attractive option, particularly for refinancing long tenored projects.
While the sukuk sector has recently seen a setback, with a number in the Gulf real estate sector defaulting on their obligations and therefore undergoing restructuring in order to allow issuers to meet their commitments, longer term expansion is anticipated. As a result of the global financial crisis, sukuk issuance in MENA slipped to $10bn in 2008, down from $10.8bn in 2007, although it held up better than conventional bonds which fell to $4bn from $13.5bn, notes Abu Dhabi Commercial Bank Executive Vice-President Arul Kandasamy. However, thus far sukuk market growth is constrained by the investor base, which is limited to banks, with the specialist investors that prevail in conventional bonds (often as a result of government and regulatory incentives) not present. If that should change, appetite could increase markedly.
Islamic funding for project finance has been limited by geographical boundaries relating to a reluctance to conduct business in other currencies, and as a result most Islamic banks have focused on their domestic markets. If Islamic banks could be encouraged to lend cross-border it would help to increase liquidity, because there are major players in Saudi, Qatar, UAE and Kuwait. If they were all available for a deal these Islamic facilities could be upsized to a point where they would become a primary consideration for borrowers targeting their financings, said Mr Hinch. This makes plans to implement a common GCC currency more pressing given the strategic importance of attracting funds to finance the regions projects.
Varying Interpretations
The varying interpretations of Shari'a scholars that sit on banks boards over whether structures comply with Islamic principles has also discouraged some sponsors and their advisers from considering Islamic financing on projects. The solution is to standardize the market and get rid of some of the white noise, said Mr Alchaar, noting that the problem is being addressed by AAOIFIs growing list of industry standards, which now number over 70. He warned that dissent from one scholar has the potential to ruin any Islamic transaction, which presents an unquantifiable risk to would-be users. For example, dissent on the acceptability of some sukuk structures adopted by a number of companies spooked the entire sukuk market, say Islamic finance experts. Project sponsors and Islamic banks have a vested interest in greater uniformity so we can get away from this conundrum of whether a structure is compliant here, but not compliant there because there are a different set of standards, agrees Mr Robinson. This is the end game that would increase transparency and investment in developing these structures, he added.
In sum, the pervasive effects of the credit crisis have profoundly changed project finance. Deals will now take longer to arrange, and will see shorter tenors, tighter structures and a greater focus on lender protection, such as the material adverse change (MAC) and market disruption clauses (MEES, 22/29 December 2008). Financings in any sector will take longer to arrange, and the pricing will be higher. But these difficult market conditions bring opportunities as sponsors focus on liquidity, liquidity, liquidity, emphasizes Mr Robinson. This is the best time for a new entrant or product to enter into the market, to really get a reaction, he said. For Islamic financiers the pendulum has swung in their favor, giving them a chance to promote new structures and work with new borrowers, he said.
In sum, Islamic financiers should not be content to shoehorn structures into conventional products, but become more creative in their own right, according to both Islamic finance experts and project advisors. They can provide alternatives to conventional products, where appropriate, rather than reinventing the wheel, but the current situation also provides them with blank slates on which genuine innovation can be written.
Copyright MEES 2009.
