Share the article
twitter-iconcopy-link-iconprint-icon
share-icon
Middle EastMay 4 2009

Can Islamic finance plug the funding gap?

The global financial crisis has limited the finances available for major projects in the Middle East. But this could be an opportunity for Islamic financiers to come up with sharia-compliant finance to make up for the shortfall of Western funds. Writer James Gavin
Share the article
twitter-iconcopy-link-iconprint-icon
share-icon
Can Islamic finance plug the funding gap?

The clogged-up arteries of the global financial system have constrained the availability of project financing, leaving a void that many projects sponsors are struggling to fill.

For Islamic financiers, the draining of conventional liquidity from the system presents an opportunity to ensure that sharia-compliant tranches remain on the structured finance menu if and when activity does pick up again.

Recent years have seen project backers look with renewed appetite for sharia-compliant financing structures as core elements of their financing requirements, responding both to shareholder pressure and the need to secure more diverse sources of liquidity.

Islamic project finance structures bring together istisna'a - a sale of assets to be constructed, effectively enabling a project to be financed while it is being built - with ijara, an Islamic lease covering the post-completion period. Such Islamic project-finance structures have emerged as viable tools for portfolio diversification.

Windows of opportunity

They have also enabled both pure Islamic institutions and Western banks with Islamic 'windows', such as HSBC, BNP Paribas and Calyon, to manoeuvre for market share in the Gulf. The latter have established Islamic units that do not require the running of a separate book, but it is enough to gain these banks exposure to some lucrative deals from which they might otherwise have been excluded.

Demand for sharia-compliant funding among borrowers has been robust in recent years. Those project financings with an Islamic component have typically seen a 70/30 split between conventional and Islamic tranches.

Crisis insulation

Islamic institutions are set to remain important players. Many Islamic financial institutions have managed to insulate themselves from the subprime fallout. "Pure Islamic banks have not suffered the sort of losses that Western banks have on mortgage products and asset-baked securities," says Bimal Desai, head of Allen & Overy's Dubai banking practice and an adviser to the Islamic lenders on $2.2bn Islamic facilities raised by Dubai Electricity and Water Authority.

Many Middle Eastern banks are liquid enough in their own currencies. But, warns Mr Desai, there is still the liquidity crunch to deal with. "The fact they can't fund at Libor affects them as much as it affects anybody," he says.

Middle Eastern Islamic banks are well positioned in terms of local liquidity, but the lack of access to dollars affects them as much as any bank - and this will put a limit on their ability to support the large project financial transactions on a par with recent years.

Islamic banks have been unable to match the pre-crisis borrowing rates close to Libor, and lending up to 80 basis points above that. They have also struggled to obtain new customer deposits to support lending.

Fitch Ratings included Abu Dhabi Islamic Bank (ADIB) - one of the most prominent of the Gulf's sharia-compliant institutions - among 18 Gulf Co-operation Council banks downgraded in a December 2008 credit rating revision.

Tenor-liability mismatches remain a structural flaw in the region. Deposits tend to be short term while lending is on a long-term basis, causing banks difficulties when it comes to the syndication process, whether Islamic or not. Banks are trying to develop the sukuk market to provide more funding, but these efforts are still in their infancy.

Islamic precedent

Why, then, the outreach to Islamic finance to help shore-up the project finance market? There has been a precedent for Islamic tranches to come to the rescue of large transactions that encountered ­difficulties. Back in late 2001, Abu Dhabi managed to complete the country's largest ever project financing, for a $1.6bn independent power and water plant at Shuweihat, which at the time carried the longest tenor for any deal the region at 20 years. This was only possible with the inclusion of a significant Islamic tranche, which provided the extra liquidity to fill a hole left by conventional banks that had taken fright. This deal, more than anything, set a benchmark for future Islamic participation in the Gulf.

But it may be expecting too much for Islamic financiers to repeat the job on a wider scale, even if the 2007-08 period witnessed some impressive deal flow. Last year, Saudi Basic Industries Corporation's $10bn Saudi Kayan petrochemical project included the largest Islamic tranche for a greenfield multi-source project financing. Even in July 2008, with global financial markets in lockdown, Qatar Islamic Bank and the Islamic Development Bank extended a $250m tranche to finance Qatar's Ras Laffan C independent power and water project, priced at $3.7bn.

Among the few sizeable deals that are currently in the market for sharia-compliant funding is the Dolphin Energy pipeline refinancing, which is seeking about $5bn in total, and the $5.5bn Ras Al Zour independent water and power project in Saudi Arabia.

Slim pickings

Otherwise, it is generally a picture of slim pickings, say bankers. "There is no project lending market. It went away in September and it hasn't come back yet," says a leading project financier at a Saudi bank. "It's misleading to refer to the existence of a syndication market - it simply doesn't exist."

One of the largest potential deals in the pipeline is the Saudi Landbridge rail project linking the Kingdom's east and west coasts. The world's largest Islamic bank, Al Rajhi Bank, is looking to underwrite the $1bn sharia-compliant tranche, out of a total funding requirement of $4bn. The plan was to have the financing package ready by the middle of this year, but this may be optimistic. "Major international banks won't even extend an auto-purchase loan in their own country, much less a 15-year project in Saudi Arabia," says the Saudi banker.

Those deals that are getting through the door mainly involve short-term tenors, such as Abu Dhabi's recent closing of a $500m deal for the development of Khalifa port at Taweelah.

Here and there, Islamic institutions can take on full exposure for large loans. For example, in January, ADIB extended a $395m Islamic loan to help fund construction of the Zayed University campus in Abu Dhabi.

If the mega-sized deals of recent years are unlikely to be repeated over the coming year, it still leaves space for Islamic institutions to play a supporting role in anticipation of better times ahead.

"Islamic financing has supported recent bids that would normally have been covered by conventional financing," says Craig Nethercott, co-head of White & Case's Islamic Finance practice.

"Although we are not seeing any significant new financings coming to the market, and commitments for underwriting transactions have reduced substantially, Islamic finance players are filling that hole to an extent," he adds.

Does it make a difference?

While large, sharia-compliant Saudi banks such as Al Rajhi and National Commercial Bank are offering bigger commitments than in previous years - between 2001 and mid-2007, of the six Gulf project financings involving an Islamic tranche, five were met by the sharia windows of conventional banks - experts question how much of a difference they can make.

"It is certainly true that Islamic banks such as Al Rajhi are more liquid than others, especially in riyals, but generally speaking there isn't a huge difference between the position of Islamic and conventional banks," says Mr Desai.

The demand is for liquidity, whichever source it comes from. "The view of sponsors will be to tap available liquidity wherever it is," says Peter Goodall, head of Calyon's project finance unit. "The big question on Islamic financing is whether it amounts to extra liquidity or is it simply lending that a bank might route Islamically for a particular reason."

This view is supported by the Saudi banker: "Islamic finance is not necessary as an additional source of funds but an alternative method of lending. It is only an additional source of funds to the extent that there are one or two banks which have sharia-compliant structures."

The past couple of years have seen Western bankers and lawyers increasingly comfortable with piecing together complicated project finance arrangements involving some hefty Islamic tranches. They have gained more understanding of issues surrounding liability and risk. The hope must be that the fallow times ahead will not see those skill sets lost for good.

Was this article helpful?

Thank you for your feedback!