The Japanese supervisory body has allowed banks under its watch to engage in so-called Islamic finance at their overseas branches starting this month. It was previously allowed only at their subsidiaries. Acting early will further secure Japan's rightful place as a leading financial market in a fast evolving global system. It will also strengthen links with the Middle East and Southeast Asia -- two of Japan's fastest growing export markets.
In 2014, the U.K. became the first sovereign government outside the Islamic world to use sukuk, followed by Hong Kong, South Africa and Luxembourg.
More recently, the British government-backed export credit agency guaranteed a $913 million sukuk issue by Dubai-based airline Emirates to purchase four new Airbus A380-800 aircraft, expected to be delivered this year.
This is the first time U.K. Export Finance has guaranteed an Islamic bond. It follows a clear logic: Emirates is the largest customer of Airbus and more than 100,000 people are employed creating the aircraft wings in Wales when including the supply chain of more than 400 companies.
The deal is a good example of how the growth of Islamic finance is being supported by global trade flows.
Sukuk's rise is driven by the growing influence of consumers who want investment and savings products compliant with Shariah laws and principles. Interest is strong in the Gulf Cooperation Council member states and in growing economies such as Malaysia and Turkey. For those seeking finance, offering Shariah-compliant debt offers access to the large pool of capital in oil-rich countries in the Middle East and Southeast Asia.
Islamic principles are at least 1,400 years old. Modern Islamic finance emerged after the oil price rise in the 1970s, which transferred wealth to the Gulf energy producers and led to the founding of large Islamic banks. Globally, sukuk issuance reached $116.4 billion in 2014 and is forecast to cross the $100 billion mark again in 2015.
Islamic law prohibits the payment of interest. Instead, those who invest in sukuk -- for example, to help fund the building of an airport -- gain a share in owning the asset and so are entitled to a share in the airport's revenues. Once the sukuk is issued, it can be traded on local capital markets.
The need for large investment in infrastructure -- roads, railways, ports and housing -- offers opportunities, notably in Asia and emerging markets in general. In February, the Group of 20 major nations committed to explore how sukuk could be used more widely as a financing tool for infrastructure. The International Monetary Fund will now take this forward.
Islamic finance is becoming part of normal retail and corporate banking in core Muslim countries, such as Saudi Arabia and Malaysia. Sukuk also has broader appeal, particularly in the Muslim world, where borrowers are attracted by the prospect of cross-border flows from the Gulf countries.
As an asset class, it is fast maturing. Longer tenors, perpetual bonds and "hybrid capital" issues allowing a mix of debt and equity are all now commonplace among sukuk instruments. This was not the case 10 years ago.
This innovation has triggered growth in Shariah-compliant financing, which represents a clear opportunity for Japan as the country enters an inflection point in Prime Minister Shinzo Abe's efforts to revive growth and confidence through "Abenomics." Weak or negative growth, increased asset purchases by the Bank of Japan and government bond yields below the rate of inflation have made it clear to Japanese corporate investors that they have no alternative but to increase overseas investment.
Signaling a desire for greater financial exchange with the Islamic economy in the Middle East and Southeast Asia is a natural first step for Japan. High-level financial developments may seem like gestures, but they can set the tone that supports greater trade in the real economy, as the U.K.'s aircraft financing deal illustrates.
For Japanese banks, demonstrating engagement with Shariah-compliant finance will open new opportunities in the Islamic economy.
The trend has already begun.
In the last six months, Bank of Tokyo-Mitsubishi UFJ became the first Japanese commercial bank to issue sukuk, the Japan International Cooperation Agency and the Islamic Development Bank struck an alliance to develop Shariah-compliant products and Sumitomo Mitsui Banking Corp. set up an in-house Shariah advisory board.
Engagement with Islamic finance will also benefit the large Japanese corporations active in the Middle East and Southeast Asia, especially in sectors such as infrastructure, transportation and consumer goods. Following U.K. Export Finance's innovative logic, might the purchase of Japanese-made desalination equipment financed by a sukuk guaranteed by the Japan Bank for International Cooperation be a future possibility?
Consider also the new opportunities sukuk will open up for Japan's vast institutional investors. These asset owners are diversifying like never before. Public-sector funds such as the $1.2 trillion Government Pension Investment Fund are selling domestic assets and increasing their exposure to overseas markets. This seismic shift could drive $500 billion of outflows from Japanese investors into international bond markets over the next two years, according to HSBC Global Research.
Japan has much to gain from closer engagement with the Islamic economy. That is why it is right to be among the early adopters.