Will Sukuk FDI Fill the $200 Billion Infrastructure Funding Gap for Bangladesh?

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Acreditus notes that despite Bangladesh's Islamic banking’s share of the of the domestic banking system at ~22% (~US$30bn) and fast growth of ~15% (double the global trend), sukuk (and bond) issuance remain negligible. 

However, with domestic liquidity tightening for multiple reasons, it is clear that new and longer term funding sources will be key to the country's future growth prospects. Infrastructure and microfinance (through Fintech) are two critical sectors could tap undersupplied sukuk capital markets to drive improved Foreign Direct Investment, financial inclusion, innovation and productivity gains. 

Sukuk are naturally suited to tangible asset financing and especially public-private-partnerships. More recently we have sukuk innovation at the micro-end of the market (Blockchain microfinance sukuk in Indonesia), thus helping to fulfil the social impact promise of Islamic Finance.

Greater strategic policy support coupled with coordinated, transparent long-term funding programmes for government related entities and structural reforms are needed to improve institutional investor access and boost growth of the capital market.

MACRO RECAP

1: Some challenges but overall a healthy, stable and fast growing economy in a low growth world..

Bangladesh ranks as the 41st largest economy, with a nominal GDP of US$314Bn (2018). Manufacturing was the major contributor to the country’s GDP and ready-made garments were the key exports. The country has emerged as one of the fastest continuously growing economies in the world. Annual GDP growth has remarkably exceeded a healthy 4% since 1995 with an average of more than 7% across the past five years. To sustain this trend and to push the country up the economic value chain, massive investment is needed into infrastructure

" In excess of 4% GDP growth since 1995 and 7% since 2016"

As the fourth most populous Muslim country and ninth terms if GDP (see full report appendix), the Bangladesh banking sector ranks a commensurate eighth with banking assets of around ~US$30Bn. The industry has grown in recent years owing to strong public demand for Islamic products and regulatory support from the Central Bank. Islamic banks account for 23.7% of total deposits in the banking sector and 12.1% of the total branches. However, the overall islamic asset ranking is relatively low 17th - driven primarily by an unusually negligible government or corporate sukuk issuance and tiny Takaful industry (more common).

Although globally the banking sector has only around 1.9% of the global Islamic bank assets. However, Bangladesh is showing asset, financing and deposit growth rates of a healthy ~15%, double the global IFI average of around ~7%.

"at ~15% Bangladesh’s Islamic banks are growing at twice the global trend"

Bangladesh’s financial sector is heavily dominated by banks and despite this strong foundation however the local sukuk (and bond) market remains oddly non-existent. As such, with limited debt/sukuk capital markets, corporates have few funding alternatives and hence makes them vulnerable to the tightening liquidity conditions in the country. In other jurisdictions, IFIs often lead the issuance by necessity.

A deeper sukuk market should provide:

(i)     longer-term liabilities - key for infrastructure finance (ii)  sovereign sukuk - key for bank liquidity management tools and yield curve (iii)  improved resilience of the sector.

As noted the Sukuk (and Bond) markets are grossly underdeveloped in Bangladesh versus other Islamic (and Asian) counties. Only the Bangladesh Government’s Islamic Investment Bond (BGIIB)’s two Islamic bonds with a tenure of three and six months respectively are currently in operation with the outstanding amount at BDT104Bn (US$1.23Bn) as of May 2019. A new $1bn AAA IFC-backed issuance is due in November.

We propose four key drivers are blocking the growth of the sukuk (and bond) market:

(i)    Lack of regular, rated sovereign issuances and hence local yield curve (ii)    Limited domestic institutional investor base (iii)  Limited Islamic bank issuances. (iv)  Issuance costs and distorted domestic credit pricing dynamics.

2: A US$200Bn infrastructure funding gap will need foreign sukuk and bond investors

A detailed study by the Global Infrastructure Hub estimates US$600bn is needed to 2040.

Bangladesh is fortunate that the global search for yield has driven a much higher risk appetite for Emerging Market assets and pension funds worldwide are struggling to source the longer-term assets necessary to fulfil their liabilities making it a great time to access the conventional and Islamic credit markets.

Sukuk, which are perfectly suited to tangible asset development and profit-sharing type structures would be a key path to increasing FDI from the growing pools of Islamic investment liquidity around the globe while simultaneous providing high quality assets for the Islamic banking sector.

"Sukuk are perfectly suited for the tangible asset and profit share nature of infrastructure and PPP finance"

Infrastructure projects can be grouped into three broad risk categories that drive the investor appetite for such investments:

Lower risk sukuk/bonds. Regulated sectors with government related and monopolistic off-takers and hence limited/zero price risk. Underlying standalone risk is likely investment grade suited debt-type instruments although sovereign rating ceilings may require some credit guarantees/wraps.

Higher risk sukuk/bonds. Open sectors where prices are subject to competition and supply/demand dynamics. Likely sub-investment grade standalone credit profiles although again, credit wraps/could possibly be applied in the conventional bond space (eg health, education, manufacturing etc).

PPP Sukuk/bonds. These projects involve public-private-partnerships with tangible assets and inherently have a risk/reward structure that make them 'perfect' from an Islamic Finance perspective. PPP policy environment is still evolving hence projects can still fall into either risk category.

Direct lending to infrastructure projects will remain difficult for the Islamic banking sector until the large asset/liability mismatch of their funding profile is addressed which will not happen in the near term.

3: Islamic Fintech: A new dawn for inclusive capitalism

Despite being the global leader in microfinance ('MF') with a deep MF industry and many ongoing initiatives, 50% of the total population still does not have a bank account. Rural populations tend to be more shariah sensitive and as such, Bangladesh can leverage the existing strength in conventional microfinance into Islamic microfinance for a greater financial inclusion.

One area where Islamic finance could be more effectively used is as an alternative to interest-based lending - is in supporting the development of entrepreneurial talents among low and middle-income group of the economy.

"Fintech innovation is critical in providing support to micro-entrepreneurs and SMEs"

Financing of start-ups and small businesses could be done through Islamic finance with more profit-sharing and/or equitable financing as they would not require collateral reducing the financial pressure on would-be entrepreneurs.

Application of new technologies such as blockchain to crowdfunding sukuk and machine learning will be key to reduce operational and transaction costs as well as improving the access of low-income customers to various microfinance services via mobile devices.

Micro-sukuk, which are certificates of small denominations have been launched that could serve as an attractive savings and investment product for the clients of Islamic banks and NBFIs. Islamic MFIs would benefit by issuing Sukuk, which could help in reducing the dependence on volatile customer deposits for funding.

Crucially however, tight, expensive and onerous restrictions regarding foreign exchange will preclude sukuk FDI into the microfinance sector, hence it will be a domestic retail fund mobilisation channel.

4: Infrastructure and microfinance could be catalysts for sukuk market growth in Bangladesh

The local sukuk markets and the Islamic insurance industry are still at a nascent stage in the country but there is extraordinary potential given the scope of sukuk (and bonds) to both address some of the longstanding financial inclusion issues and development objectives to help the country and its people move up the economic value chain.

Development of local capital markets for both domestic and international investors will create a transparent and risk-adjusted new channel for foreign capital and reduce reliance on the banking sector that is facing its own challenges and unable to support the infrastructure needs of the country.

Lastly, in addition to the macro economy, sukuk finance has enormous potential at the micro end of the scale to help drive more inclusive growth. Success will require a proactive and supportive regulatory environment to thrive with an emphasis on new technologies.

The costs around capital markets are high and suited for large institutions, only fintech, blockchain and tokenisation will allow the origination, transaction and securitisation costs to fall sufficiently for a more equity and asset-backed form of finance to become reality and help avoid the easy addiction to debt-fuelled consumption that has proven to be a volatile, exclusive and stagnating source of growth.

Sources: World Bank, IMF, Moody's, S&P and Fitch Rating Agencies, IFSB and Global Infrastructure Hub

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