Ever since Malaysia began its recovery from the effects of the Asian economic and financial slump three years ago, Islamic finance has been at the forefront of fundraising for domestic projects. The total volume of project deals in Malaysia financed on an Islamic basis was more than RM10 billion ($2.6 billion) in 2000, says Jason Kho at Deutsche Bank's Kuala Lumpur debt capital markets team. A similar volume of Islamic project deals is expected in 2001.

A large number of upcoming project financings are scheduled for the Islamic market, they include: Perlis Power, Sepang Power and the Expressway Lingkaran Tengah (Elite) road projects. The Sepang deal, which will like the Perlis deal will be a bond financing, is being led by Bank Islam Malaysia and Bank Muamalat Malaysia. Leads for the Perlis financing have not yet been revealed.

The Malaysian authorities began to make changes to encourage the Islamic market as far back as 1983 and since then have drawn up a wide range of Islamic finance-friendly laws and incentives including waiving stamp duty on Islamic loans. However, it is only since the Asia crisis and the rise of the Malaysian project bond business, that the Islamic finance industry has also begun to flourish.

According to Jerry Yeoh, the head of HSBC's debt capital markets department in Kuala Lumpur, it is wrong to regard Islamic and conventional finance in Malaysia as two separate markets. ?Many of the investors and players are the same in the Islamic market as in the conventional market in Malaysia,? he says. Due to Malaysia's exchange controls it is rare to see foreigners (for example, Middle Eastern investors) in Malaysian Islamic finance transactions. In addition, almost all domestic and most foreign banks active in the country have Islamic banking units.

Apart from underlying lending principles, Islamic project finance transactions are different from conventional project financings in one all-important respect ? pricing. ?Sponsors who finance on conventional lines pay a 5 to 25 basis points premium over Islamic project deals,? says Say Yong Chan at Citibank's Kuala Lumpur Corporate Finance department.

The pricing relationship between the dual sides of the Malaysian project finance market is similar to the pricing correlation between A and B tranches of a dual share listing says a third Kuala Lumpur-based banker. ?The pricing level may be different but the two pricing trends still move largely in step with the other,? he explains.

One banker speculates that the pricing levels will start to converge in the next couple of years. His view is not shared, however, by most other financiers. ?If a particular project financing can satisfy Islamic financing principles, it is open to a wider pool of investors in Malaysia than a conventional financing. That's because Muslims who would not be willing to participate in a conventional financing can participate, demand is greater and therefore the price to the sponsors can be lower. This situation is not going to change over time.?

Ample appetite
Five months ago, several bankers expressed concerns that appetite for Malaysian project bonds, Islamic or otherwise, might run dry in the face of the large volume of deals, particularly power sector deals, expected in the first half of 2001.

Malaysian investors already have substantial exposure to the power and water industries through the swathe of projects financed over the last two years. Compounding the exposure issue, most projects in the power sector have been structured in near identical fashion.

Tenaga Nasional (TNB) is usually the offtaker and paymaster and investors rightly view such deals primarily as TNB risk.

So far, however, fears about indigestion have proved unfounded. The most recent power project financing, a RM420 million, seven-year commercial paper/medium-term note (MTN) issuance for Malakoff, closed in mid-April with an over-subscription rate of six times the issue amount.

Malakoff
The transaction, led by Citibank, Commerce International Merchant Bank (CIMB) and Malayan Banking Berhad finances the ongoing construction at Malakoff's GB3 power plant in Segari, Perak. Specifically, funds will used to finance Malakoff's equity portion of the project.

Chan says the issue was very well priced, close to where the Swap curve was at the time of the financing, as well as being heavily oversubscribed. The Malakoff deal did, though, feature several important characteristics that not all project bonds or developments enjoy.

Firstly, the Malakoff bond is highly rated by the Rating Agency of Malaysia, with a long term rating of AA1 (the short term rating is P1). Chan says that investors in Malaysia are currently worried that a number of local issues could be downgraded in the coming 12 months, largely because of the slowdown of the global economy and the possible impact on Malaysian corporate earnings. ?But its very unlikely that an AA1 issued bond is going to collapse to a BBB or below investment grade rating,? says Chan, ?and that's why investors found considerable comfort in the deal.?

In addition, a Malaysian electricity industry research analyst notes the strategic importance of Malakoff's Segari plant. ?Offtake by Tenaga Nasional from Segari is high, at around 85%, driven by the plant's location in the central region,? says the analyst.

The GB3 development is also one of three IPP projects put on fast track by the government due to the energy shortage that Malaysia now faces. The energy shortage is a result of the strong economic growth the country has enjoyed recently and the fact that a number of IPP schemes were canceled in the Asian financial crisis.

Chan says the debt portion for Malakoff's expansion plan, which is expected to be in the region of $300 to $400 million, will be raised in the next few months.

?Investor demand for power project bonds has continued to be high while the supply of paper has actually been lower than was expected,? says Deutsche's Kho. Kho believes that demand will persist for power sector bonds as long as they have a credit rating of AA or above. Chan meanwhile, disagrees that Tenaga's pivotal role in power sector project financings is a particular concern to domestic investors. ?The local market at least looks beyond Tenaga,? says Chan, ?they know that there is very little chance that the government would allow Tenaga to default on its debts.?

Malaysian fund managers will have plenty more opportunity to be investors in local power projects. Joe Casson, also at Citibank, says that about RM8 billion is scheduled to be spent on power developments either in form of expansion projects, or recapitalizations linked to privatization.

Sepang Power and Powertek control the other two fast track IPP projects being pushed by the government. Casson says that Sepang and Powertek will need funding facilities to be lined up in the first half of this year.

Sepang recently awarded Siemens a RM1.5 billion mandate to build its 710MW combined cycle gas turbine plant in Kuala Langat, Selangor. At the same time, Powertek is in the process of upgrading its original Malacca plant with the addition of a 720MW combined cycle facility, expected to come on stream in 2003.

Another independent power producer, Perlis Power is said to be looking for RM1 billion of financing for its power plant project in Perlis, but, says one Malaysian banker, ?the timing of the Perlis deal is questionable as the full sponsor list for the power plant is still being negotiated.? Perlis has commissioned Alsthom Power to develop its 650MW plant. The project is estimated to cost a total of RM1.2 billion.

Both Sepang Power and Perlis are understood to be planning private debt securities issues worth over RM1 billion each to finance their projects. Perlis Power is said to be keen on an Islamic offering. Bankers say the company has begun talks with Bank Islam Malaysia and Bank Muamalat Malaysia for a bond offering.

Industry observers expect ratings for both companies to be AA. The majority of IPP bonds are rated AA on account of the strong cashflow currently enjoyed by Tenaga.

Powertek, likewise, is expected to secure a AA rating. In its favour, analysts say the company has a strong internal cash generating ability and its level of indebtedness is low.

Powertek has short-term borrowings of RM113 million (only 15% of shareholder funds). The IPP has a further RM440 million in long-term borrowings from the purchase of the Tanjong Kling plant from Tenaga, but repayable only in 2005.

Bankers do still caution that the bond market could tighten considerably mid-year after the hefty RM5.5 billion refinancings of the STAR and Putra light rail transit systems has found its way into the market. Previous lenders to LRT, including HSBC and other foreign banks, will receive bonds in return for loans to the organization. ?The on-selling of these loans may soak up a lot of appetite,? says one banker.

Roads, dams and gas
Similarly, the $2.4 billion Bakun dam project on Borneo island is destined for the bond market where it will absorb a large volume of investor funds. The exact timetable for Bakun's fundraising program, however, has not yet been worked out.

Overseas firms will be heavily involved in the building of the dam, says an official in the Malaysian finance ministry. Before the original plan for the dam was put on hold four years ago (due to the Asian crisis) Construction contracts were handed out to a consortium made up of ABB and Companhia Brasileria Projectos e Obras (CBPO) of Brazil.

When the government took back the privatized project from Bakun Hydro-Electric Corporation in 1999, ABB said their contract was still valid and it is not yet clear whether the Malaysian government will revive the mandate.

Foreign participation (other multinational engineering companies including Alsthom are hoping to participate) could open the way for a large export credit portion in the fundraising. For that reason, several French banks are rumoured to have already talked over financing options with the government.

French interest or no, Project Finance also detects a good deal of skepticism about the development amongst the project finance community. The proposed dam has a troubled history. The original plan was to build the dam in east Malaysia but have most of the power consumed in west Malaysia. ?That plan would have required a submarine power cable to be laid at unprecedented depth and over an unprecedented distance,? says a Singapore-based banker, ?and the technology to make that work was unproven.? The revised plan, the financier adds, is to supply power only to east Malaysia. ?But,? he says, ?its by no means apparent that sufficient demand exists.

Indeed, if the dam is built we are probably going to have chronic oversupply in the east.?

Several long-awaited road projects are also expected in the Malaysian bond market this year. The sponsors of the Silk road project, for which Deutsche Bank is the sole lead arranger, are still awaiting government approvals for the project. Kho says most regulatory hurdles have, at least, been cleared. Due to the poor history of past toll road projects in Malaysia, Kho also says that Silk has gone through a more rigorous stress test in terms of traffic revenue forecasts.

Silk's sponsors are believed to have sought opinions from three separate specialized traffic forecasting firms to satisfy the ratings agencies. ?Silk will definitely get an A rating,? says a second source close to the project.

The Elite road project being led by PJB Capital is several months ahead of Silk. ?Elite is finalizing the compliance process and the lead manager is trying to place the deal in the bond market now,? says a former adviser to the project. Unlike Silk, Elite does not feature credit enhancements, says the source.

One of the more eagerly awaited projects for the foreign banking community is the RM3 billion joint gas pipeline to be built between Thailand and Malaysia. The development is of particular interest to foreign banks because it is likely to be a US dollar deal. ?Gas is a dollarized commodity,? says Casson, ?and the gas transported by the pipeline could potentially be exported.? Bankers report that the project company for the pipeline has now been set up but a mandate for financial advisor has not yet been awarded. Nor is the timetable for the project clear. The pipeline has stirred up considerable environmental angst in Thailand, which has threatened the very existence of the scheme. At the end of April, however, Thai Prime Minister Thaksin Shinawatra said his Government would honour its agreements to develop the project subject to the Environmental Impact Assessment now underway.