The Korean Ministry of Strategy and Finance announced earlier this month that it had submitted a tax revision to the National Assembly, which if approved would pave the way for local companies to start issuing sukuk (Islamic bonds). Yet even if the law is passed Islamic finance faces stormy times. Regulators and lawyers may benefit from looking at the troubles that Japan has had in kickstarting its own industry.
Existing hurdles
Under existing Korean legislation uncertainty surrounds whether a sukuk meets the definition of a bond.So far this has meant that Islamic bonds did not stand to benefit from the tax incentives provided for foreign currency denominated bonds. "The hurdles are typical of those you find in conventional financial markets,” said Lee Do Heon, managing director of the global business department at Korea Investments & Securities Corporation. “The main hurdles are taxation issues relating to double stamp duty, VAT, capital gains and the definition of what constitutes a security.”
This has placed Korean institutions wanting to launch Islamic products domestically in a difficult position. “From a conventional point of view sukuk, for instance, may look like an asset-backed security or like investment certificates … in a conventional mortgage it is like lending with collateral,” Lee said. “But in Islamic mortgages of diminishing musharatza the bank must purchase the property and co-owns the asset with the mortgagee …under Korean legislation commercial banks are not allowed to buy property for purposes other than [establishing] headquarters or branches.”
Under the proposals currently before the National Assembly, sukuk may become beneficiaries of the benefits currently offered to other foreign-currency denominated bonds. In theory, this would establish a legislative framework for a domestic Islamic finance market. “Adoption of a regulatory framework for the issuance of sukuk in Korea is a step forward in the development of capital markets and the country’s ambition to become a financial hub,” said Brendon Carr, a foreign lawyer with Hwang, Mok & Park. “During 2008 there was a lot of discussion [as to] whether a sukuk was a ‘bond’ as defined in law. That frightened away institutions from making such offerings … now we may have a framework to activate that market.”
Why Islamic finance?
In the past fear may have been a deterrent to the success of the Islamic finance industry, yet worldwide this is something that Korean companies can no longer afford to be frightened of. Latest estimates indicate that Islamic financial assets are expected to surpass US$1trn in 2010. Sukuk issuance grew five-fold over the past four years to reach US$120bn in 2008 and the mutual fund market is estimated to reach more than US$11bn.
Korea’s chaebol have made no secret of their desire to tap into the Gulf region’s ever-increasing pool of investors to feed their infrastructure activities in the region. But as the GFC dries up financing funds from traditional funding markets, this ‘want’ is quickly transforming into a ‘need’. “The sub-prime crisis – as well as the bankruptcy of Lehman Brothers – has limited the sources of funding available for Korean companies… and while this has started to improve, Korean companies may still find it difficult to raise and obtain capital in traditional markets like the US and Europe,” said Park Soo Man, a partner at Kim & Chang. “The fact that Islamic finance offers non-synthetic, non-complicated and real financial transactions mean it could have a big role to play in Korea.”
Natural appeal
Just how much of a role Islamic finance will play in Korea is still unclear. Ahn Sang Jin, a partner at Kim & Chang, said that although this will depend on what the final form of the new regulations will be sukuk could debut in Korea as early as mid-2010. “There are a number of Korean companies looking into the possibility of Islamic products at the moment but we won’t really know until the law is promulgated,” he said. “What we do know is that there a lot of crossovers between the activities of Korean companies and Islamic finance – so launching a sukuk may be a popular option.”
The ‘crossovers’ Ahn refers to may be one of the biggest factors determining the success of Islamic finance in Korea. “Korean financial institutions are well-suited to helping develop the local industry because of their experience in social overhead capital projects and facility financing, which are at the core of shariah financing,” said Min Euoo-sung, chairman and CEO of the Korean Development Bank. He added that in addition, there are a number of other commonalities which could be used as fuel to fire the domestic industry.“Reflecting on the preference of Islamic finance institutions for long-term investments in large-scale deals, a consortium of Islamic financial institutions may also seek to invest in many of our global corporations… [and on the other hand] the high US dollar liquidity of Islamic countries make investment there very attractive for Korean companies.”
Korea Investments & Securities Corporation Lee agrees. “It is very natural that the Korean market welcomes more stable and long-term investment, such as Islamic finance,” he said. “The Korean economy has a very strong industrial base. This is a very good fit with the ethos of Islamic finance so that it impacts on the real economy into productive investments.”
Not so new overseas
While Islamic finance may be a relatively new product domestically, Korean companies have a long history of tapping these capital markets internationally. The Korean Development Bank was one of the first. “KDB drew [some] of its early financing from the [Gulf] region with its first IFB issuance in 1974 in UAE dirham and Kuwaiti Dinar,” Min Euoo-sung said. In addition, other Korean chaebol such as Lucky Goldstar (LG) and Daewoo have been accessing Islamic trade finance facilities structured mainly through the London market since the 1980’s.
There have also been a number of successful instances of venture capital funds attracting investors into Korea, by setting up Islamic funds of which STIC’s Pioneer Fund II (US$200m), Oryx/STIC’s Korean Technology Fund (US$150m) and another PE pre-IPO buyout by STIC, are three examples.
Domestic fortunes
While Korean companies are willing to use Islamic finance internationally and there is a natural synchronicity between their activities and the tenets of Shariah-compliant products, Islamic finance faces a number of hurdles domestically. The most insurmountable of which seems to be that there is no captive local market for Shariah-compliant products.
“It is difficult to provide retail banking services exclusively for Muslims in Korea due to the limited size of the market, not to mention the different regulations of Islamic financing,” says KDB’s chairman. “It could be possible to initially open a window exclusively for Muslims in order to provide them with various retail banking products, but costs and revenues [will depend on] economies of scale and the break-even point.”
All of which, in Min’s opinion, may open a window for Korean corporations to take the lead themselves. “Issuing a debut sovereign sukuk is worth a try, especially as [Korean companies] have accumulated know-how and experiences in managing bond underwriting,” he said. Just as there are regulatory and economic hurdles, so too are there cultural ones. The relative youth of Shariah-compliant products in Korea means that it is yet to achieve a level of acceptance in the market to make a domestic industry feasible, let alone profitable.
Japan
Those who are looking for a glimpse of what a domestic Islamic finance industry may look like in Korea two or three years from now need only look as far as Japan. Here, despite recent regulatory changes establishing a domestic Islamic finance market, the initiative has spectacularly fallen off the radar with few predicting that the idea it will regain traction any time soon.
Etsuaki Yoshida, deputy head of Africa and the Middle East with the Japan Bank for International Cooperation, said much of this can be explained by the relative ‘newness’ of Islamic products to Japanese investors as well as major cultural issues. “Since Islamic finance has a relatively short history, some things are not fully standardised,” he said. “Many Japanese people prefer to stay away from anything ambiguous … Islamic finance is difficult for the Japanese. Japan is isolated from the international community and there are unique language and cultural barriers.”
Naoki Ishikawa, a partner at Mori Hamada & Matsumoto, cites ambiguity in the Japan’s Banking Law as another major issue. “Sukuk is still not clarified under the Japanese law [as to] whether they constitute bonds or trust beneficiary rights,” he said. “Other issues that still need to be resolved include those relating to the assets transferred to the SPC (special purpose company) in the sukuk structure; harmonisation with the conventional government bond framework and governmental procedures for asset transfer in asset-backed sukuk.”
Fundamentally, there is little impetus to establish a framework for a domestic market given that Japanese companies, just like their Korean counterparts, have been so active and so successful in tapping overseas Islamic capital markets for funds. Aeon Credit was the first Japanese corporate to issue a sukuk (in 2007) when it raised a total of US$45.3 m in two issues in Malaysia. In recent times, Daiwa Asset Management launched the Singapore Stock Exchange’s first Shariah-compliant exchange traded fund, the Daiwa FTSE Shariah Japan 100. Toyota announced its plan to enter the market with a MYR$1bn (US$306m) issue to raise funds for its auto leasing and loans business in Malaysia.
And Kuwait's Boubyan Bank completed what is believed to be Japan's first property deal using Islamic financing – and the bank’s first real estate investment in Japan – when it bought three office buildings in Tokyo for JPY4.38bn (US$41.4m). Not to mention Nomura’s acquisition of Lehman’s Europe and Middle East operations in 2008 and MUFH’s 20% acquisition of Morgan Stanley. “Japanese companies have long used Islamic capital markets to raise funds for their outbound activities,” said Ishikawa. “This has always proved a more efficient and cost-effective way to tap into Islamic finance markets and has meant that there is little appeal for local issues.”
The lawyer added that recent amendments to the country’s Banking Law may increase see an increase in this trend. “The new article [law] will allow subsidiary companies to conduct Islamic finance, which is a very positive development,” he said. “But at the moment, it does not allow banks to buy or sell assets as part of their business and this is an important part of Islamic finance. There are also some taxation issues which need to be resolved … but we hope that these will be addressed soon.”
The future
Consensus, it seems, is that investors shouldn’t hold their breath on either a Tokyo or Seoul-originated sukuk in the foreseeable future. Yet it may also not be as far off as one thinks. It is well-known that Islamic finance dovetails nicely with Korea’s ambitions to establish Seoul as a North-Asian financial centre, along with Japan’s desire to solidify its standing as one of Asia’s international financial hubs. Add to this the fact that both have stated their desire to catch up with the faster-developing Islamic finance markets of Singapore and Malaysia.
While lawyers eagerly await legislative action, there appears to be more than enough interest emanating from ambiguous legal landscapes in both places to keep structured finance and banking practitioners busy. The key for law firms, it seems, is realising that now is the time for investing resources in growing – or building, as the case may be – Islamic finance practices. “There is no doubt that every lawyer will be interested in Islamic finance work,” said Kim & Chang’s Park. “It is a new area of law here, and has the potential to be very profitable, especially for law firms that can get into the area early.”
With a dearth of deal flow in each country, training lawyers, of all things, could halt growth plans. The key, according to Mori Hamada’s Ishikawa, is increasing domestic firms’ exposure to international practices and developing a sustainable model for an Islamic finance practice of their own.
“Some of my colleagues have been working with international law firms, particularly UK and Malaysian firms, to get an understanding of the most important issues on Islamic finance deals, particularly how they are structured,” he said. “So far, this has proved successful and has enabled us to start building up best practices in relation to this area … but with such little activity it hasn’t been easy.”
If shariah-compliant products take off in Korea and Japan, should we expect to see law firms in these countries looking to inorganic means to build their practices? All of the lawyers ALB spoke to could not rule out making Islamic finance-related strategic hires to anchor their practices, or forging ‘deeper ties’ with colleagues in the Gulf region and/or South East Asia to achieve the same purpose. The latter certainly wouldn’t be out of the ordinary for Korean or Japanese law firms who have displayed a penchant for expanding into frontier practice areas (and frontier markets) on numerous occasions. Islamic finance is one area where law firms in Japan and Korea will need to find equilibrium between the demands of client-led growth and strategic expansion.
This is an extended version of the piece which appears in ALB issue 9.12
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