Islamic banking is one of the fastest-growing segments in international finance. Indonesia is home to the world's largest Muslim population (around 210 million), yet its share in Islamic finance is still low. Neighbouring Malaysia, with less than a tenth of Indonesia's population, has effectively turned itself into a global leader for sharia-compliant banking. But Indonesia's new Financial Services Authority (OJK) looks determined to help the country catch up.
At a time when conventional investment products in developed economies have lost appeal due to their unattractively low yields, investors around the world are turning to sukuk, a kind of bond that is permitted under the Koran. Compared to conventional securities, sukuk usually offer higher returns and are considered fairly safe because they are backed by tangible assets. For Indonesia, this is an opportune context to carve out for itself a greater share of the global market. Realising the potential that Islamic finance holds for Indonesia's emerging economy, such as funding massive infrastructure development (See Indonesian Infrastructure: Tremendous PPP Opportunities), deepening the country's capital markets and making them more resilient to global downturns, the government has committed itself to help the industry grow up. A mature Islamic capital market could help local companies reduce foreign borrowing and heralds new business opportunities in the financial sector.
Islamic finance experienced something of a global boom in 2014, with a number of major economies entering the market. The UK, Hong Kong, South Africa and Luxembourg all issued their first-ever sukuk, despite Muslims representing just a minority of their respective populations. Indonesia successfully marketed a dollar-denominated 10-year sovereign sukuk in September 2014. Almost seven times oversubscribed despite offering a modest yield, the $1.5 billion USD issuance became a stamp of approval from the investor community. Moody's Investors Service expects the strong growth momentum in the global sovereign sukuk market to be sustained. Demand and liquidity in the market should improve as the sector attracts more global investors and as new governments enter Islamic capital markets, the credit rating agency said in a press release in September 2014. Likewise, the corporate sukuk market is drawing growing interest even outside the Muslim world, with western banks beginning to use sukuk to raise money. Goldman Sachs Group issued $500 million USD in September, while Société Générale and Bank of Tokyo-Mitsubishi UFJ were also planning to tap the Islamic bond market.
Indonesia has 12 sharia-compliant commercial banks, 163 Islamic rural banks and 22 sharia business units (sometimes referred to as Islamic windows) operated by non-Islamic banks, according to OJK data for August 2014. The number of sharia banks is on the rise, while that of sharia-compliant windows is decreasing, and regulations require that parent banks spin off sharia units by 2023, which could spur industry consolidation over the coming years (See The Outlook for Indonesia’s Islamic Banking Sector). Together, Indonesia's sharia banks held assets worth 251 trillion RP (around $20.8 billion USD) as of August 2014. This amounts to less than 5% of domestic banking assets and fades in comparison to Malaysia, where Islamic banks hold more than 20% of total assets and Saudi Arabia, where it is more than 50%. But growth in Indonesia has been fast in recent years, with sharia-banking assets rising at a compound annual growth rate (CAGR) of 35% from 2010 to 2013. The low market penetration of Islamic financial products suggests that the potential is far from exhausted. In a 2013 study of the global industry, consultancy firm Ernst & Young projected Islamic banking assets in Indonesia to grow at an average rate of 33% per year to more than $100 billion USD in 2018.
Source: Financial Services Authority (OJK)
As for mutual funds, the combined net asset value of 66 sharia-compliant funds was 9.6 trillion RP, or 4.5% of the total fund industry. Assets of Indonesia's 49 sharia-compliant insurances (as of May 2014) stood at 19.3 trillion RP, or 4.25% of the national insurance industry. Forty-eight sharia-compliant financing companies had total assets of 25 trillion RP, or 5.51% of the industry's total.
An uncertain legal environment has been blamed for the low engagement of foreign banks in Indonesia, including in the Islamic banking segment. Institutional and regulatory reforms have been slow in the making, despite the government's “Blueprint for the Development of Islamic Banking” dating back to 2002 and Bank Indonesia's “Grand Strategy for the Development of the Islamic Banking Market.” Law No. 21 of 2008 on Sharia Banking did little to assuage concerns, given that more recent banking regulations introduced an ambiguous 40% ownership cap in Indonesian banks, which some observers believe could be arbitrarily applied to limit foreign control (See Indonesian Banking Sector Outlook: In Need of a New Growth Strategy). Foreign investor interest clearly exists, though, as reflected in Dubai Islamic Bank's acquisition of a 25% stake (possibly to be raised to 40%) in Bank Panin Syariah in June 2014.
The recent handover of regulatory authority in the financial sector from the central bank and the former capital market watchdog Bapepam-LK to the OJK, however, appears to be a catalyst for reform. The OJK has promised to refine rules for Islamic securities and insurance products and is reportedly working on revised capital requirements to bring the risk management at Indonesian sharia banks in line with international standards defined by the Malaysia-based Islamic Financial Services Board (IFSB). The move could help to better integrate the country's Islamic banks into the global financial system. The OJK also said it was moving forward with an overdue reform of Islamic pension fund rules in response to popular demand.
In August 2014, the OJK set up an Islamic banking committee aimed at fostering coordination between government bodies and the private sector in a bid to support the industry. The OJK expects the committee to foster the creation of innovative financial products and to provide guidance on the application of Islamic law to these products, which should bring greater legal certainty. More importantly, the OJK, which has considerable clout in shaping financial sector policies, is working on a five-year plan to expand the country's Islamic capital market. This would address issues including a lack of scale in the industry, sector consolidation and the role of foreign ownership, Reuters news agency reported in August 2014, adding that the plan might include incentives for the domestic sukuk market.
Indonesia has come a long way in the short time since the country issued its first global sukuk in 2009. Sukuk will remain the heavyweight Islamic asset class in Indonesia (and globally) for the foreseeable, future, buoyed by the immense capital needed for infrastructure development and which local banks are often unwilling to lend at the required tenures. Yet it is the retail market potential that truly sets the world's fourth-most populous country apart from other centres of Islamic finance. Tens of millions of Indonesians remain largely disconnected from the financial system and have no bank account. On the back of the country's economic ascent and a quickly-growing consuming class, this provides fertile ground particularly for rural Islamic banks offering deposits and the equivalent of personal loans (See An Outlook on Indonesia’s Microfinance Sector). Also, Islamic insurance (takaful) and mortgages come to mind. As personal incomes rise over the next years and decades, sharia-compliant mutual and pension funds should gain a stronger foothold.
In a largely unexplored Indonesian market however, and particularly in rural areas, banks will need to invest considerable resources to educate the population on the merits of sharia-compliant financial services. Compared with larger Islamic banking marketplaces, Indonesian retail banking customers are culturally less homogeneous, more pragmatic, and tend to make economic decisions based on non-religious practicalities rather than on religious doctrine. Innovative products can overcome this issue by offering sharia-compliance without compromising on attractive services and conditions. The OJK, for its part, has vowed to promote Islamic finance across the nation and to tackle the shortage of qualified human resources in the business. While it remains to be seen how the new Islamic Finance committee may improve the regulatory environment and what incentives the OJK's five-year plan entails, Indonesia is, without a doubt, a market that investors and advisers in the sharia finance business will want to keep an eye on.
Global Business Guide Indonesia - 2014
Contribution to GDP: 2.55% (Q3 2015)
Return on Assets: 2.31% (Q3 2015)
Number of Commercial Banks: 118; 4 State/Partially State Owned, 10 Foreign, 11 Joint Ventures, 28 Non Foreign Exchange, 39 Foreign Exchange, 26 Regional Development Banks (August 2015).
Number of Islamic Banks & Units: 12 Banks, 22 Units (2015)
Total Assets: 6,244 trillion IDR (Q3 2015)
Government Bodies: Bank Indonesia, Ministry of Finance, Financial Services Authority (OJK).
Relevant Law: Bank Indonesia Regulation No. 14/8/PBI/2012 on Share
Ownership in Commercial Banks limits ownership by a single local/foreign financial institution to 40%, by a non financial institution to 30%, and by an individual to 20%. Larger stake is possible with the approval of Bank Indonesia.