Funding growth without debt

Think Piece By Prof. Dr. Obiyathulla Ismath Bacha

A number of contradictions appear to be plaguing the Muslim world. Sukuk, the most popular fundraising instrument of Islamic finance, has seen declining issuance in 2015 relative to previous years. That this is happening at a time of increased need for infrastructure funding is a contradiction. The OECD estimates that approximately US$ 71 trillion will be needed globally by 2030 for investments in roads, rail, electricity, water and other basic infrastructure. Much of these needs are within the Muslim world. Ironically, of all sukuk issued thus far, less than 10% has gone into the funding of infrastructure. This is indeed surprising since the shariah requires investments to be in real assets, be long term in orientation, have returns anchored in real sector returns and bring benefits to society. Development infrastructure has all these features. They are tangible, can provide revenue over their long economic lives and bring both economic and social benefits to the ummah.

So, why hasn’t more sukuk gone into the financing of development infrastructure? There are both demand and supply side reasons for this. If as argued, supply creates its own demand, the structure of sukuk currently being brought to market (supplied), can explain its insignificance in development financing. Much of the world’s outstanding sukuk are really debt or quasi debt instruments. The majority of outstanding sukuk are Ijarah (lease), Murabaha (trade credit), Salam and the like, all of which are essentially fixed-rate contracts. Like conventional debt, these debt-based contracts require fixed servicing and thereby increasing leverage and macroeconomic vulnerability. Furthermore, most of these sukuk are short to medium term with maturities mostly within 5 years. If sukuk look and behave like bonds, there is no value added to Muslim nations that issue them in lieu of debt.  In fact, there may be distinct disadvantages relative to a bond issuance. The most obvious being the higher issuance costs from the need for an underlying asset, an SPV and ownership transfers etc.. Thus, from the demand side, it is no surprise that countries looking to raise infrastructure funding, look elsewhere but at sukuk.

These nations need growth without leverage. Ironically, the solution to growth without leverage lies within Islamic finance. The risk-sharing contracts, Mudarabah and Musyarakah being hybrid equity, avoid the fixity of debt while providing the flexibility of equity. Governments that typically issue bonds to raise the debt to fund infrastructure can instead use innovative sukuk such as a convertible Mudarabah sukuk to raise equity-like funding. For example, suppose a government intends to build a power generation plant whose output will be distributed and sold through the national grid.  Since the project will generate revenue and profits, risk-sharing structures that involve profit/loss sharing can provide the same funding at much lower risks. Revenue generating development infrastructure typically require heavy upfront investments but provide very stable cash flows for extended future periods, the next 50 to 100 years. Instead of issuing bonds in western financial markets and incurring currency exposure, reduced financial flexibility, increased debt service ratios and the many constraints that come with increased debt, governments could issue convertible Mudarabah sukuk. Much of these could be sold locally, with a needed portion overseas. Financial inclusion can be enhanced through issuance of a portion in small denomination. The recent experience of Egypt in raising funds domestically for the second Suez Canal, is a case in point.

Since the power plant project involves construction during which no revenue is produced, the sukuk should be a convertible Istisna- Mudarabah structure. Assuming it takes three years to build the plant, the sukuk pays nothing in the three years during which the Istisna contract in force. On completion, as revenue begins to be generated, the Mudarabah kicks-in with profits being shared with sukuk holders. This could go on for perhaps the next 7 years, years 4 to 10 of the project. At end year 10 when all ancillary and supporting infrastructure has been built and power generation has achieved expected full capacity, the entire project could get listed through an IPO (initial public offer). Sukuk holders can either choose to convert their sukuk to listed shares and become shareholders or sell their shares and redeem their investment at market value. The IPO process is important as it enables sukuk holders to capture the upside of their investment. Such upside potential also makes it palatable to go through the first three years (construction period) without any returns.

If all the needed funds for the project are raised through the proposed sukuk, there is no pressure whatsoever on government budgets. Governments merely provide the land and facilitate the project and for this gets a portion of the stake and receives its share of sukuk. At IPO, the government too becomes a shareholder and continues to share in future project revenue. Since none of the constraints of debt is applicable here, the government technically faces no limits in the number of projects that can be undertaken. As long as there are economically viable projects, the government can initiate such an investment. The key to success would be good governance. The reason the world shies away from equity and is biased towards debt has to do with information asymmetry. Risk-sharing must necessarily mean the sharing of only the project’s risk and no other risks like political risk, or risks arising from corruption, mismanagement and the like.

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